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By Christine Benz | 09-27-2010 11:23 AM

Vanguard's Davis: Expect Muted Returns for Bonds

Low current interest rates are one of the biggest reasons to expect below historic-like returns in the bond market, says Vanguard's chief economist.

Christine Benz: Hi. I'm Christine Benz for Morningstar.com.

Following a decade of tepid returns for stocks and relatively better gains for bonds, a lot of investors appear to be expecting the same, but should they be?

Here to discuss those questions is Joe Davis. He is chief economist for Vanguard.

Joe, thanks so much for joining us today.

Joe Davis: Thank you, Christine.

Benz: So you and your team arrive at expected market returns for various asset classes, and I'd like to talk about some of them, but first I want to talk about how you arrive at those expectations, what do you look at?

Davis: The process – well, it's a mix of quantitative approach, as well as qualitative approach. The key to understand for your listeners is that we produce a range of outcomes that there is no point forecast to this. It's very statistical, it's actually driven by various risk factors and some historical relationships, but we also build in a great deal of uncertainty. Statistically speaking, things such as fat tails and other things that we know historically can lead to, in times of stress, correlations going to one.

And if anything, we go well and beyond historical record to see what potentially could have happened that did not. So again, we're doing the best we can to incorporate uncertainty, but that said, we also look very closely at the central tendencies as well to get some sense of the implications they may have for portfolio construction.

Benz: So I want to start by talking about fixed income. Your team has relatively muted expectations for fixed income. Let's talk about what you're looking at there? And I'd also like to home in on TIPS and what you're thinking about for TIPS?

Davis: Sure. Just broadly, first, fixed income. One of the key attributes of our simulation returns is that they incorporate initial conditions, which traditional Monte Carlo simulation tools explicitly do not, and that's a key distinction.

And when you do that, we all know that interest rates, generally speaking, are much lower today than they have been, and it's those initial conditions that matter. And the biggest reason why we have below historic like returns, I mean, yield to maturity is actually a pretty decent predictor of future bond returns.

And we also do incorporate some higher yields over a long period of time, and so because in part of that reversion, you tend to have below yield like returns, at least as the central tendency. That's broadly for all asset classes, whether its TIPS, as well as just Treasuries or corporate bonds.

Benz: Okay. So from a practical standpoint, investors looking at this feel like they're between a rock and a hard place. They know they need the security of fixed income, but you've got rock-bottom yields and the prospect of higher rates. How should you navigate?

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