Portfolio Design: A Modern Approach to Asset Allocation

RECONSIDERING BOND RETURNS

But what real returns can we expect in the future? As stated above, real compound returns on bonds since 1951 have averaged 2.2 percent. But many investors recall much higher returns over the last few decades. Huge capital gains enabled bond investors to earn equity-like returns. In fact, during the 1980s, bonds and stocks earned almost identical real returns of about 9 percent.

Bonds had splendid returns in the 1980s and early 1990s for a very simple reason. Inflation and bond returns fell over this period. Soon after Paul Volcker was first named to lead the Federal Reserve in 1979, the inflation rate started to recede from historic highs. That’s because Volcker and the Fed instituted a tough monetary regime aimed at sharply lowering the double-digit inflation that the country was experiencing.

Figure 2.3 shows the inflation rate and 10-year Treasury bond yield over the period since the early 1950s. After Volcker succeeded in driving inflation to low single digits, the bond yield stayed stubbornly high for a time. But eventually the bond market adjusted as inflationary expectations fell. As a result, bond returns soared. Investors in this market benefited whether they bought and held high coupon-paying bonds or sold out their bond positions after registering large capital gains.

FIGURE 2.3 Inflation and Bond Yields, 1954–2009

Data Source: IMF, International Financial Statistics.

Some investors are waiting patiently for high bond returns to resume. ...