Why bonds are back thanks to higher rates (2024)

Bond investors had their patience tested by two years of negative returns in 2021 and 2022, as prices fell in response to central banks raising interest rates sharply.

The good news is that bond returns have recovered this year¹ and the long-term outlook for bonds is better than it has been for many years.

We expect UK bonds to deliver annualised² returns of around 4.4%-5.4% over the next decade, compared with the 0.8%-1.8% 10-year annualised returns we expected at the end of 2021, before the rate-hiking cycle began.

Similarly, for global ex-UK bonds, we expect annualised returns of around 4.5%-5.5% over the next decade, compared with a forecast of 0.8%-1.8% two years ago.

Here we answer your questions on why the outlook has improved – and why bonds may have a place in a portfolio.

Why bonds?

Bonds are a type of loan issued by governments or companies, which typically pay a fixed amount of interest and return the capital at the end of the term. Once issued, bonds are traded, like shares, and their prices can fluctuate.

Bonds can play a key role in investors’ portfolios by smoothing out returns from higher-risk assets such as shares. While shares have historically delivered higher returns than bonds over the long term, they also come with higher volatility (or swings in prices). Holding some bonds in your portfolio can therefore help to offset some of this volatility over time.

When interest rates were at record low levels, bond investors became used to returns being relatively muted. However, we believe that higher real (inflation-adjusted) interest rates mean that holding bonds now has the potential to contribute meaningfully to the total return of an investor’s portfolio.

But what about the last two years?

The past few years have been challenging because bond prices have fallen as interest rates have risen sharply. Bond prices tend to fall when interest rates rise because existing bonds paying lower interest become less attractive. As prices fall, bond yields (which show the income as a proportion of the price) rise and vice versa.

But that’s not to say bonds have lost their role in a balanced portfolio (a portfolio spread across global shares and bonds) – in fact the long-term outlook has improved.

Why has the long-term outlook improved?

While higher rates may hit bond prices, long-term investors stand to benefit from higher yields, which will likely offset previous losses and lead to better total returns over time when reinvested and compounded. Compounding means you earn a return on the reinvested income.

The chart below shows this in action. Someone who invested £100 in global bonds in May 2021 saw the value of this investment fall to around £90 by the end of November 2023.

However, based on our current forecast of annualised returns of around 5% over the next 10 years, the investment would be back at £100 by early 2026 (shown by the gold line). It would also be at nearly £130 by the middle of 2031, which is above the value it would have achieved if interest rates had stayed low (and therefore if annualised returns had been around 1.3%, as we forecast in 2021 and shown by the green line).

Remember, though, that these returns are hypothetical and are not a guarantee of future results. They represent our forecast for a 10-year period, meaning there could be years when returns are lower than forecast (or negative) and years where they could be higher. They do demonstrate, though, the potential benefits of staying the course over the long term rather than making knee-jerk reactions based on short-term losses in markets.

Rising rates mean higher returns for long-term investors

Past performance is not a reliable indicator of future results. Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

Notes: The chart shows actual returns for the Bloomberg Global Aggregate Bond Index Sterling Hedged along with Vanguard’s forecast for cumulative returns over the subsequent 10 years as at 31 December 2021 and 30 September 2023. The forecast range represent the ranges from the 10th to the 90th percentiles of the forecasted distributions.

Source: Data from Refinitiv as at 30 November 2023 and Vanguard calculations in pounds sterling as at 30 September 2023.

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 31 December 2021 and 30 September 2023. Results from the model may vary with each use and over time.

What should I do?

As an investor, the proportion of bonds in your portfolio should reflect your goals and your attitude to risk. If you have shorter-term goals (for example, you may need the money in less than ten years) or have a lower appetite for risk, a higher proportion of your portfolio in bonds may be more appropriate.

If you are still comfortable that the proportion of bonds is right for you, it is worth staying the course for the long term. Sometimes the best course of action – if you have the most appropriate portfolio for you – could be to do nothing.

¹ After negative total returns for global bonds of -1.5% in 2021 and -12.2% in 2022, total returns from 1 January 2023 to 7 December 2023 are +4.2%. Source: Vanguard calculations based on data from Refinitiv as at 7 December 2023, based on year-to-date performance of Bloomberg Global Aggregate Bond Index Sterling Hedged (hedged back to local currency to manage currency fluctuations).

² Annualised returns show what an investor would earn over a period of time if the annual return was compounded (i.e. the investor earns a return on their return as well as the original capital).