Hold Bonds for Diversification, Not Returns

Roland Czerniawski: In this week's chart, we look at historical 10-year forward returns of long-term government bonds and their relationship with the starting interest-rate levels. The light- and dark-blue bars represent average annualized real and nominal returns for a 10-year period following various starting interest-rate levels, measured here as a 10-year Treasury yield.

The chart reveals, not surprisingly, that there is a strong relationship between the starting interest-rate level and the future bond returns. There are two ways to think about this issue. First, yield is a big component of bond returns, so it's not shocking to see a correlation between the two. Second, bond prices tend to decline in rising-interest-rate environments and vice versa. So, when yields are low, the probability of rates rising in the future years is higher--which, in turn, cripples the forward returns.

Currently, the 10-yield Treasury yield is around 2.4%, which historically has provided an average 10-year forward nominal return of just 2.5% annually. While in the short run, bond-return rallies like the one we saw in 2014 are possible even around those low-yield levels, in the long run, the gravity of rising rates will depress future bond returns. 

Investors should be aware that while bonds should still be able to provide portfolio diversification benefits and steady income in future years, they will most likely not be a source of meaningful returns in the next 10 to 15 years.