• Interest rate movements and expectations of future movements affect bond market returns.
• Trying to time bond market participation around the interest rate cycle is risky and very difficult to execute.
• A diversified bond market exposure has outperformed cash and short-term bonds over the long term.

After a turbulent two years for bond markets, the long-term return outlook for the asset class is at its most attractive in decades, thanks in no small part to interest rates.

Major central bank policy rates rose rapidly between the end of 2021 and summer 2023—the European Central Bank’s deposit facility rate rose from 0.0% in July 2022 to 4% by September 2023 – coming down to 3.75% in June 2024. The rise in rates means investors earn significantly more income from bonds issued since rates began to rise compared with those issued in the previous decade.

This rise in income returns marks an important shift in the contribution of bond income to total portfolio returns.

While the income component of bond returns has improved significantly, price returns have suffered over the past 18 months. Many investors still recall the anguish of 2022’s annus horribilis for bond markets—when global bonds posted double-digit losses while global equities also fell sharply (for the first time since 1977¹). The reason behind the fall in bond prices and subsequent volatility comes down to interest rates and, more importantly, the market’s expectations of future interest rates.

Now that interest rates have begun to recede from their recent peaks – and with the US Federal Reserve also primed to cut its target rate range in the near term – now is as good a time as ever to explore the role of interest rate movements in bond market returns.

Why have bond markets been volatile?

The volatility in bond markets since 2022 is a function of duration risk², which refers to a bond’s sensitivity to interest rate changes. Bonds with longer durations are more sensitive because the value of their future payments falls if newer bonds with higher coupons are issued under a higher interest rate environment. Falling rates would typically cause long-term bond prices to rise.

This repricing of bonds is based on the return an investor would receive if they held the bond to maturity (yield-to-maturity). If rates are going up, existing bond prices tend to fall because investors can earn more on newer bonds with higher coupons, so the price of existing bonds typically drops. The opposite is true when rates are falling.

While it might sound like a simple relationship that investors can exploit to their advantage, markets—including many professional investors—can and often do get it wrong. If interest rates don’t move as expected, for example, investors that have taken a tactical position with their bond holdings could suffer far greater losses than a bond portfolio that is diversified across the yield curve.

In the case of government bonds, expectations about future interest rates can have an even bigger impact on bond prices than actual movements in rates. This is because when the policy rate, set by central banks, is expected to rise or fall in the future, parts of the market will adjust their bond holdings to optimise returns, which can see prices move further based on increased demand.

As the chart below demonstrates, the short-term correlation between actual bank rates and bond yields (which move inversely to bond prices) is low. As interest rates were rising in the first half of 2023, bond yields rose, but the grey-shaded area shows how yields fell significantly while rates remained flat. This is a function of the market pricing in rate cuts – albeit too early – sending bond yields down before coming back up again as markets adjusted their expectations.

Low correlation between bond yields and central bank rates

Past performance is not a reliable indicator of future results.

Notes: For the US: Yield-to-Worst of Bloomberg US Aggregate Bond Index and Federal Funds Target Rate (upper bound) from January 2023 till June 2024. The federal funds rate is the target interest rate range set by the Federal Open Market Committee (FOMC). This is the rate at which commercial banks borrow and lend their excess reserves to each other overnight. For the euro area: Yield-to-Worst of Bloomberg Euro Aggregate Bond Index and European Central Bank (ECB) Official Bank Rate from January 2023 till June 2024. The Bank Rate determines the interest rate the ECB pays to commercial banks that hold money with the central bank.

Keep it safe, keep it diversified

The rapid rise in rates in the US, euro area and the UK triggered heightened volatility in bond markets as some investors tried to market-time their participation. For example, some investors went to cash and short-term bonds to avoid the volatility and take advantage of higher rates on cash. However, at some point, those investors will likely want to shift back towards a traditional, diversified bond exposure to benefit from any rebound in bond prices should rates fall – and they need to do this before the market prices rate cuts in.

Ultimately, bond holdings have historically offered a counterbalance to the volatility in equity markets³, so it’s important for multi-asset investors to think carefully before introducing further risk to their bond exposures by shifting from short- to long-term bonds.

The outlook

Our economists think interest rates are likely to continue receding from their recent peaks – but we’re not going back to zero. That’s because the neutral rate of interest, that is, the level at which interest rates are neither stimulating or restrictive to economic growth—also known as r-star—is now higher than before the global financial crisis of 2008. We think the higher interest rate environment will last for years rather than months and represents a structural shift that will endure beyond the next business cycle.

And higher starting rates are good news for bond investors. Our long-term return expectations for bond markets have improved significantly since the rate-hiking cycle began and, as a result, so have our expectations for lower-risk multi-asset portfolios, too. The chart below shows our latest 10-year annualised return expectations for euro investors across different equity/bond splits.

Solid prospective multi-asset returns

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

Notes: The forecast corresponds to the median of 10,000 VCMM simulations for 10-year annualised nominal returns in EUR for multi-asset portfolios highlighted here. Asset-class returns do not take into account management fees and expenses, nor do they reflect the effect of taxes. Returns do reflect the reinvestment of income and capital gains. Indices are unmanaged; therefore, direct investment is not possible. Equity comprises global equities, represented by the MSCI AC World Total Return Index. Fixed income comprises global bonds (hedged), represented by Bloomberg Global Aggregate Bond Index Euro Hedged.

Source: Vanguard calculations in EUR, as at 31 May 2024.

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 modelled asset class. Simulations are as at 30 June 2024 and 30 September 2023. Results from the model may vary with each use and over time.

As the chart shows, our annualised median return expectations for lower-risk portfolios are similar to the higher-risk, higher equity-allocation portfolios. That’s down to the improved return outlook for bond markets and, in our view, stretched US equity valuations.

The difficulty of trying to position portfolios tactically is why maintaining a globally diversified exposure to markets is a prudent investment strategy. Where we are in the current interest rate cycle offers further reason to ensure client portfolios include a diversified exposure to global bond markets that aligns with their long-term goals and preferences around risk.

¹ Source: Bloomberg. Note: Annual total returns calculated in USD from 1977 to 2022. For equities, we use US equities represented by the MSCI USA Index from 1977 to 1987 and global equities afterwards, represented by the MSCI ACWI Index. For bonds, we use US bonds represented by the Bloomberg U.S. Aggregate Index from 1977 to 1990 and global bonds afterwards, represented by the Bloomberg Global Aggregate Index Value (USD Hedged).

² Duration risk refers to a bond or bond portfolio’s sensitivity to interest rate changes, accounting for characteristics such as yield, coupon rate and maturity. Bond prices move inversely to changes in interest rates, so that if interest rates rise (or fall), bond prices fall (or rise). The longer a bond’s duration, measured in years, the more sensitive its price to interest rate changes.

³ Vanguard analysis based on Bloomberg data. Analysis of annual total return of global equities and global bonds between 29 December 2001 and 31 December 2022 found that global bonds delivered a positive return in five of the six years that global equity markets posted losses. Bonds: Bloomberg Global Aggregate Total Return index (hedged in EUR); Shares: FTSE All-World Total Return index (in EUR). The performance of an index is not the exact representation of any particular investment. As you cannot invest directly into an index, the performance does not include the costs of investing in the relevant index. Basis of performance NAV to NAV with gross income reinvested.