The 10-year US Treasury yield, at 0.77% as of October 19, is still near historical lows set earlier this year. Historically, 10-year Treasury performance for the next 10 years has tended to track the Treasury yield at the start of the period, as show in the LPL Chart of the Day. By that measure, the return outlook for the 10-year Treasury is just about as low as it’s ever been. As discussed in last week’s blog, Under-the-Radar Signal That Rates May Head Higher, right now the 10-year Treasury yield is not even enough to compensate for inflation, a very unusual relationship historically, but more common in recent years due to low interest rates.
“All else being equal, a 10-year Treasury yield of about 0.75% points to an expected annualized return of about 0.75% over the next 10 years, likely lower if rates rise,” said LPL Financial Chief Market Strategist Ryan Detrick. “But getting anything more than that from a bond allocation means taking on more risk, which may put more conservative investors in a tough position.”
The main reason for the close relationship between future returns and current yield is that, unlike stocks, with most bonds you know the price you’ll get when the bond matures—it’s just the face value of the bond. Essentially, the lender gets back the original value of the loan the bond represents, with interest collected along the way. When you know the price you’ll get, it’s easier to figure out the expected return. The yield combines the return from the price changes and the interest payments.
While the path of yields over the ensuing 10 years did make some difference, deviations from the forecasted value weren’t large. 78% of the 10-year return observations were within one percentage point of the yield at the starting point, although the worst forecasts were off by around 3%. The overall bias is for the forecast to be too low when yields are falling, as we’ve experienced since 1981, and too high when yields were rising, as we’re likely to experience over the next 10 years given how low yields are now.
So what are bond investors to do? For the most conservative investors, Treasuries, which have no real default risk, are still a very safe choice, although even they can experience short- to intermediate-term losses when interest rates rise. If taking on more risk is an option, carrying only modest Treasury exposure in a bond portfolio with diversification to corporate bonds and mortgage-backed securities (MBS) may add some return potential. Ultimately, stocks have the best return prospects, but also carry substantially higher risk. Even with their lower return potential, quality bonds may still act as a portfolio diversifier while likely offering potential gains in the long run, even if at lower levels than what we’ve seen in the past.
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