Vanguard to bond holders: Bumpy ride ahead

The Vanguard Group Inc. sent out a warning signal to bond investors Monday. In a blog post on the Vanguard website, the world's largest mutual fund manager cautioned investors about lower returns and heightened market sensitivity from the traditionally staid fixed-income asset class. Since 2000, the U.S. bond market has provided net returns of 8.4%, versus 2.4% for the U.S. stock market, according to Vanguard. But Vanguard's chief economist Joe Davis believes that future returns on fixed-income investments are likely to fall well short of the historical norms. “Arguably the single best predictor of the future return on a bond portfolio is its current yield to maturity, or coupon,” Mr. Davis wrote in the blog Monday. “For many bond mutual funds, this could imply a possible return over the next several years in the 2% to 3% range.” That could spell trouble for the investors who piled into bonds at an unprecedented pace over the past four years. Currently, taxable bond funds hold $2.3 trillion in assets, up from around $1 trillion in 2008, according to Morningstar Inc. Obviously, the expected returns are nothing to cheer about. But Mr. Davis' prediction of higher volatility in bond markets may be even more worrisome for investors. With such low yields — high-quality bonds are generating less than 3% these days — there's no cushion to counteract any short-term rise in interest rates, Mr. Davis said in an interview. “In the past, the income could help dampen any volatility from losses,” he said. For example, if the yield on a long-term Treasury rose 100 basis points back in the 2000s or 1990s, there was enough yield to make up for the loss of principal value. That's no longer the case, since the 30-year Treasury is yielding 2.74% and the 10-year 1.65%. Although interest rates are at historic lows today, that alone is no guarantee they'll go back up, Mr. Davis said. “This notion of mean reversion comes up all the time,” he said. “It seems to go hand-in-hand with low rates that there's some law of gravity that they have to go back up. Ultimately, it depends on the economic fundamentals.”