Webcast excerpt
What could higher rates mean for bonds?
February 16, 2022
In the face of high inflation and a low unemployment rate that continues to put pressure on wages, the Fed is widely expected to raise its target for the federal funds rate during 2022, with the first increase coming as early as March. What could rising rates mean for bond investors?
In this webcast excerpt, Sara Devereux, head of Vanguard Fixed Income Group, discusses possible short-term implications of these anticipated Fed rate hikes for investors in U.S. and international fixed income securities, as well as potential long-term effects.
Read the transcript
Massy: I heard you, Greg, say something about bond volatility in the short term as we see rising interest rates; and there was a lot of question around that. Sara, Richard from Nebraska is wondering what to expect over the next few years based on the most recent Fed announcement to raise rates.
Sara: Thank you for your question. Well I would say, Massy, as Greg mentioned, rising rates as policy normalizes—the central bank's starting to raise rates—is likely to result in some short-term volatility. Now, the good news is higher rates implies higher future returns. And as Greg mentioned, our fixed income outlook for the next decade has been ticking higher. It's now in the range of, returns in the range of 1-1/2 to 2-1/2%, which is higher than we thought last year.
When we look outside the U.S., expected returns are going to be a little bit lower than the U.S. Now, that being said, we do find value in buying hedged global bonds because there's a diversification benefit. It helps insulate against results and risks that are specific to the U.S.
If I look at another sector of corporate credit, for example, U.S. investment grade bonds are expected to outperform Treasuries over the long term. But we would say that given where valuations are, the return that you get for taking on that excess credit risk has been chipped away. So still expected to outperform but less so than it has in the past.
And then finally, I'll touch on munis. Muni rates we also expect to be going higher, largely tracking in line with Treasury rates. Now for a muni investor, this can actually be really good news because in the future this gives them potential for more tax-exempt income.
So I think overall I would probably summarize it by saying, Yes, returns are still expected to be low in fixed income markets, but if we learned one thing during the COVID-19 crisis in the market, it's that power of bonds as insulation when the equity market is selling off.
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Notes:
All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
Investments in bonds are subject to interest rate, credit, and inflation risk. Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax. While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest. Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
Asset class return projections are based on Vanguard Capital Markets Model (VCMM) projections. IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2021. Results from the model may vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
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