Why higher yields may be good for many retirement investors

Volatility in bond markets, caused in part by rising interest rates, has left many investors wondering what the current environment means for their portfolios. These concerns might be particularly acute for those nearing or in retirement given that these investors may have relatively shorter time horizons and may be more heavily invested in fixed income.

But according to Roger Aliaga-Díaz, Vanguard's global head of portfolio construction and chief economist for the Americas, and Anatoly Shtekhman, Vanguard's head of global advised portfolio construction, bonds remain an important staple in retirement portfolios and are poised to offer significantly more value.

"In addition to diversifying your portfolio to help lower your overall risk by offsetting stock market volatility, bonds are now providing healthier yields than we've seen since before the 2008 global financial crisis," Aliaga-Díaz said. “Retirement investors who might be considering reducing their exposure to bonds because of the pain endured during the recent rise in interest rates might want to reassess their situation, as the benefit of higher rates to retirement portfolios is about to come."

Components of bond returns

Bonds are unique in that their returns consist of two parts: price return and coupons or income return. The income return comprises the compounded interest on bond coupon payments.

Long-term investors, such as those with longer horizons until they retire or who are early in their retirement, should consider the combination of these two components instead of solely concentrating on bond price returns. When interest rates fluctuate, the two components tend to move in opposite directions. While higher rates may negatively affect bond prices initially, long-term investors stand to benefit by reinvesting and compounding at higher yields in the future.

Although rising interest rates always pose risk to bond investors, Aliaga-Díaz explained, higher rates for longer create a favorable environment for retirement portfolios. By contrast, the previous decade of stable but ultra-low yields was detrimental to investors' chances of accumulating sufficient retirement funding.

"With yields at their highest levels in 15 years, bonds today can offer more significant value in total returns to a portfolio, particularly if inflation continues to come down from elevated levels," he said. "As higher yields compensate for last year's capital losses, the cumulative total return should become positive."

Bonds versus cash

After the recent subpar performance of bonds, it may be tempting to wait in cash for the right moment to reinvest in bonds. But shifting your long-term portfolio from bonds to cash comes with risks to your long-term retirement goals. Over extended time periods, bonds have provided better returns.

Using the 3-month U.S. Treasury bill as a proxy for cash and the Bloomberg U.S. Aggregate Bond Index as a proxy for bonds, we compared the returns of both asset classes between January 31, 1978, and September 30, 2023, and found that bonds outperformed cash most of the time, as the next figure shows.

"While higher cash rates lead to higher cash returns, bonds are still a better alternative, especially over longer periods of time," Shtekhman said. "The safety of cash is appropriate for short-term spending needs. But when comparing the performance of bonds and cash over longer periods, bonds outperform cash in the majority of cases, even when cash yields are relatively high."

Although cash rates are currently at 20-year highs, Shtekhman added, the Federal Reserve may be nearing the end of its rate-hiking cycle and may eventually have to cut rates.

"Investors who have a large allocation to cash may be very disappointed," he said. "They need to think strategically, and unreasonably high cash allocations can be detrimental to achieving long-term investment goals."

Aliaga-Díaz cautioned that there have been prolonged periods of rising rates that led to extended stretches of negative bond market performance, most notably during the 1970s. But he argues that the latest cycle of Fed rate hikes is nearing an end and that bonds are poised for a rebound.

"We believe that long-term investors, including those saving for retirement, should focus on total returns on bonds rather than prices and let higher interest rates work in their favor by allowing the compounding to take effect," he said.