Long-term bond returns

In last month's column, we proposed that stocks could produce attractive returns, even if the coming several years do not match the returns we saw in the 1990s.

Marvin Appel, MD., PhD & Brian Hufford, CPA, CFP

In last month's column, we proposed that stocks could produce attractive returns, even if the coming several years do not match the returns we saw in the 1990s. This forecast was based on the historical tendency of stock returns to track economic growth.

Because bonds have done well over the past three years and stocks have done poorly, many investors are moving from stocks into bonds. Are there some basic principals that might allow us to estimate future prospects for newly popular bond investments? This month's column proposes that future bond returns are likely to approximate current interest rates. Because current rates are low, future returns from bond investments are likely to be well below the returns seen during the past 20 years.

Yield to maturity

The single most important dividend yield is the yield to maturity. This is the investment return you will receive by buying a bond now and holding it until maturity. It includes both interest payments and changes in the value of the bond from what you paid and the final value of $1000. As a general rule, bonds with similar maturity dates and similar apparent credit risks should have similar yields to maturity.

Principal No. 1: The projected return from bond investments is the yield-to-maturity based on current interest rates, regardless of how bonds performed in the past. For example, the Vanguard Long Term Treasury Fund (VUSTX) has returned 8.6 percent per year over the past 10 years. (Which, by the way, is almost exactly the return of the stocks in the S&P 500 Index during the same period.) But now, the yield to maturity of the fund is 4.6 percent. In other words, the future projected return is much less than the previous average return.

If you buy an individual bond and hold it until maturity, the return on your investment will equal the yield to maturity regardless of interest rate fluctuations.

As of this writing, 10-year Treasury notes are yielding 4 percent to maturity. A-rated (or better) corporate bonds of 7 to 10 year maturity are yielding from 4.6 percent to 5.1 percent per year to maturity. Investors should not expect greater returns over the next 7 to 10 years, and may in fact receive less. Bond mutual fund returns will likely be lower, since such funds typically subtract their expenses from the dividend income available to shareholders.

Principal No. 2 — The only way for bond mutual funds to consistently return more than current interest rate levels is for interest rates to decline. Conversely, if interest rates rise over the long term, returns to current bond investors will be below current yields. Interest rates are now at historically low levels. Inflation was under control during the past ten years but is now starting to heat up, due in part to sharply rising energy prices. It is expected that interest rates will not continue their 20-year downturn. Indeed, there is a risk that rates will escalate because of increased government borrowing or higher inflation.

Implications

Bond investors should be alert to the potential risks, especially since the stellar performance of investment-grade bonds during the past three years seems to have engendered widespread complacency. (Because of their low expenses and historically stable performance, we recommend Vanguard short-term corporate bond fund, ticker VFSTX, or Dodge & Cox Income, ticker DODIX.)

Do not use past returns from bond funds to set your expectations of future performance. Rather, consider the yield to maturity (sometimes also reported as "30 day SEC yield"). Invest in bonds or bond mutual funds with maturities of 10 years or shorter in order to minimize the potential impact of rising interest rates.

Dr. Marvin Appel is CEO of Appel Asset Management. He holds a degree in biochemical sciences from Harvard College and earned his MD in 1991. He is coauthor of Systems and Forecasts. Contact him at (516) 487-7146 or mappel@appelasset.com. Brian C. Hufford, CPA, CFP, is president of Hufford Investment Advisory Programs, LLC, and Hufford Financial Advisors, companies dedicated solely to helping dentists secure solid financial planning and safe investment strategies. He can be reached at (317) 848-4987.

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