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Bonds have Vanguard CEO thinking of 1999

Jan 8, 2013 @ 1:11 pm

By Jason Kephart

McNabb: Bond bubble about to burst.
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McNabb: Bond bubble about to burst. (Bloomberg)

When Bill McNabb, chief executive of The Vanguard Group Inc., sees the valuations and yields available in fixed-income today it takes him on a trip down memory lane. Unfortunately for bond fund investors, it's not a particularly rosy memory.

“You could argue it's almost as extreme as stocks were in 1999,” Mr. McNabb said during an interview last week. That year, the price-earnings ratio for the S&P 500 index bubbled up to more than 30 as stocks careened toward the tech bubble crash. The following decade was a dubbed a “lost decade” for equities as the S&P 500 had negative annual returns.

Mr. McNabb isn't predicting that bond funds will suffer the same fate over the next 10 years, but he is warning clients that they need to reduce their expectations.

“It's always dangerous to predict returns, but the probability of bonds having the same return over the next 10 years as the last 10 is almost zero,” he said.

That doesn't mean he's advocating throwing bonds out of a portfolio or replacing them with riskier assets with higher yields.

“Bonds are still a great diversifier of equities,” he said. In fact, Vanguard contends they're actually the best diversifier of equities in times of market stress.

The diversification benefits never been more costly, though. The 10-year Treasury is still yielding less than 2% and the Dow Jones Corporate Bond Index is trading at a record high of 115.

That means returns on the classic balanced portfolio, with a 40% allocation to bonds, are inevitably going to be lower. Mr. McNabb said investors can expect closer to a 5% return from the 60/40 mix of stocks and bonds, down from the historical average of about 8%.

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