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TheStreet Open House

Bond Returns Lose Their Double-Digit Returns (and Appeal)

Stocks in this article: NOTE

NEW YORK (TheStreet) -- Which is it: Past is prologue, or past performance is no guarantee of future results?

It's a key question for fixed-income investors who must try to somehow forecast bond returns now that the basic rules of the game have changed, with yields more likely to rise than to fall.

Unfortunately, the answer is not very pleasing. Today, many experts say the prudent course is to assume your total return will equal the bond's coupon payment.  For a 10-year U.S. Treasury note, that comes to a meager 2.7% a year, a far cry from the double-digit annual returns of some recent years, such as the 16% of 2011 or the 20% of 2008.

Past returns weren't always that great. But the 10-year averaged about 7% from 1964 through last year, according to an analysis by the Stern School of Business. Last year was pretty bad, with the 10-year losing just over 9% while the Standard & Poor's 500, the prime stock market index, returned about 32%.

Bond returns come in two parts. First is the interest earnings, or coupon payment. Then there's the price change of the bond itself. For several decades up to and during the financial crisis, interest rates were drifting downward. That meant investors were willing to pay a premium for older bonds that were more generous. Bond prices rose, often contributing more to the return than the interest earnings.

Now most experts expect things to change, with interest rates gradually rising. That can make the older, stingier bonds less desirable than newer bonds, causing their prices to fall.

But since investors understand that this will happen, that risk is already reflected in bond prices. If so, the bond price will neither go up nor down. With price changes taken off the table, the investor will earn only the interest payment.

John C. Bogle, founder and former chairman of Vanguard Group, recently told The Wall Street Journal that, despite short-term ups and downs, coupon rates have historically been a pretty good indicator of returns to come. Since 1926, he told the Journal, the 10-year Treasury's yield at the start of the average 10-year period has accounted for 92% of the average annual return earned in the decade that followed.

"It is today's coupon, rather than the past return, that determines the future," he told the Journal.

Of course, it might not turn out as expected. If interest rates were to rise faster than the markets expected, bond prices might indeed continue to fall, wiping out all the interest earnings and producing a net loss.  In theory, the opposite could occur as well, with falling interest rates driving up bond prices just as they did so often in the past. But since interest rates are very low by historical standards, the chances of that seem slim.

If bond returns will languish in the low single digits for the next decade, is there any reason to own bonds?

Well, even 2.7% is a lot more than you'll earn in bank savings. A five-year certificate of deposit pays just 0.755%, according to the BankingMyWay.com survey. Note, though, that the CD is insured against loss, while the Treasure note is not.

Bonds, even when they aren't very profitable, also help diversify a portfolio, offsetting some of the risks of stocks.

But many experts do suggest that investors revisit their asset-allocation plans and think about trimming their bond holdings.

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