Tuesday, February 14, 2012

Some More (Ugly) Bond Math

I've come across a number of forecasts for US Bond returns in the 4.5% - 6% range for the next 5 or so years.


Unfortunately, that is very wishful thinking.

The chart below shows that yield to maturity is awfully accurate in predicting five year forward returns for the aggregate bond index (this is because 5 years is roughly the universe of US bonds' duration). The unfortunate part is the current yield to maturity is a measly 2.06% as of today's close.


What does this mean?

It means that investors should not expect more than 2% annualized from your bond allocation over the next five years, UNLESS you are willing to reach for yield via lower quality credit, non-US exposure, or increased duration. It also means that if you have a 60% equity / 40% bond allocation, to reach an 8% all-in annualized return your equity allocation needs to return roughly 12% / year over the next 5 years. In addition, it likely means that correlation between bonds and equities are likely to increase over this time frame during times of turmoil, as bonds don't have room to appreciate in a flight to quality (more on that here).

In other words... don't expect much help from bonds (all that said, 2% still seems compelling relative to my 0% checking account).

Source: Barclays Capital