Global bond markets have repriced significantly over the last two years because of the transition to the new era of higher rates. In our view, bond valuations are now close to fair, with higher long-term rates more aligned with secularly higher neutral rates. Meanwhile, term premia have increased as well, driven by elevated inflation and fiscal and monetary outlook uncertainty.
Despite the potential for near-term volatility, we believe this rise in interest rates is the single best economic and financial development in 20 years for long-term investors. Our bond return expectations have increased substantially. We now expect U.S. bonds to return a nominal annualized 4.8%–5.8% over the next decade, compared with the 1.5%–2.5% annualized returns we expected before the rate-hiking cycle began. Similarly, for international bonds, we expect annualized returns of 4.7%–5.7% over the next decade, compared with a forecast of 1.3%–2.3% when policy rates were low or, in some cases, negative.
If reinvested, the income component of bond returns at this level of rates will eventually more than offset the capital losses experienced over the last two years. By the end of the decade, bond portfolio values are expected to be higher than if rates had not increased in the first place.
Similarly, the case for the 60/40 portfolio is stronger than in recent memory. Long-term investors in balanced portfolios have seen a dramatic rise in the probability of achieving a 10-year annualized return of at least 7%, the post-1990 average, from an 8% likelihood in 2021 to 40% today.
Moving up the risk spectrum, credit valuations appear fair in the investment-grade space but relatively rich in high-yield. What’s more, the growing likelihood of recession and declining profit margins skew the risks toward wider spreads.