Vanguard says beware of bonds

The Vanguard Group Inc. has sent a warning signal to bond investors. In a blog post on its website last Monday, 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, thinks 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,” he wrote in the blog last 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 ahead for the investors who piled into fixed income at an unprecedented pace over the past four years. Taxable-bond funds hold $2.3 trillion in assets, up from about $1 trillion in 2008, according to Morningstar Inc.

MORE WORRISOME

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 is no cushion to counteract any short-term rise in interest rates, he said in an interview. “In the past, the income could help dampen any volatility from losses,” Mr. Davis said.

ENOUGH YIELD

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 is 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, that alone is no guarantee they that will 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,” Mr. Davis said. “Ultimately, it depends on the economic fundamentals,” he said. [email protected] Twitter: @jasonkephart