KNOWING WHAT RETURN you can reasonably expect from stocks, bonds and other asset classes is valuable because it can help you make more educated asset allocation choices. It also helps you decide how much you need to be saving. If expected returns are low, you’ll need to save more.
Such estimates don’t require extraordinary clairvoyance. In fact, when it comes to bonds, estimating returns is quite straightforward. The expected return from a bond is very close to something called the bond’s yield to maturity, which is the return you would expect if you held the bond until it matures.
Many investors don’t hold individual bonds, nor should they. Instead, they ought to invest in bond mutual funds or exchange-traded funds. Fortunately, the expected return from a bond fund also closely approximates the fund’s average yield to maturity. If you know that number, you have a good handle on what return you can expect from the fund.
In the short run, the return could be higher or lower than the fund’s yield to maturity. That’s because bond prices are subject to market volatility, just like stocks. This year is a good example. The U.S. bond market—using the Bloomberg Aggregate Bond Index, or “the Agg,” as a proxy—is down almost 7% in 2022, even with interest included.
But when bond prices fall, their yields rise. The total return that an investor receives is always a combination of capital gains (or losses) and income. When the price of a bond falls, bond income can be reinvested at higher yields. These two effects—lower bond prices and higher yields—offset each other. That’s why the starting yield to maturity is a very good estimate of the total return that bond fund investors will receive over, say, six or seven years if they own an intermediate-term bond fund.
As an example, one of the largest bond funds in the world is the Vanguard Total Bond Market Index Fund (symbol: VBTLX. The exchange-traded alternative is BND). Its yield to maturity is currently 2.3%. If you’re an investor in this fund, 2.3% is close to the long-term return you can expect. It’s that simple.