Will bonds return to their former yields?
December 08, 2014
Q: I'm doing some retirement planning, and trying to figure out what return I can assume my investments will earn. We have a blend of stocks and bonds, and for years we always assumed this would be good for 8 to 10 percent from the stock portion, and 6 percent from the bonds. Now though, with the bonds yielding between 1 and 4 percent, does that mean there is no chance of them earning 6 percent over the long term?
A: While it is possible that bonds could produce a total return of 6 percent over the long-term, with yields now much lower, the odds are against it and lowering your return assumption would be prudent. A look at some of the dynamics involved in bond returns will help explain this further.
First of all, there are two kinds of yield: income yield and yield-to-maturity. Income yield is the amount of interest the bond pays annually as a percentage of its current price, while yield-to-maturity takes into account both the income yield and the shift from the bond's current price to its par value between now and maturity. If you hold the bond to maturity, yield-to-maturity is more or less the total return you will get.
Over shorter-term periods, a bond may have a higher return than a yield to maturity. A drop in interest rates could boost its price, though the odds are against much of a decline in interest rates from today's levels. For lower-quality bonds, an upgrade in credit rating might give them a short-term price boost. However, these higher returns would only be over interim periods; if the bond is held to maturity, the total return would smooth out to roughly the yield-to-maturity at which the bond was purchased.
Treasury yields currently range from 0.2 percent to just over 3 percent, with longer durations providing the higher yields. Ironically though, if you want to exceed 3 percent over the long run, your best chance might be in shorter-term bonds. Long bonds will be hard-pressed to produce a total return exceeding their yield-to-maturity, but short-term bonds will have several opportunities to roll over and thus would benefit if interest rates rise.
If you want to pursue a strategy of rolling over short-term investments in the hopes that interest rates will rise, you might consider savings accounts or CDs as an alternative to bonds. These can provide you with a U.S. government guarantee like Treasuries, but the best CD and savings account rates today exceed the yield on Treasury securities of similar durations.
But again, while there are things you can do to manage your income return, lowering your return assumptions would be prudent to keep your retirement funding on track.
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