Sep 20

What returns should bonds provide over the next 5 years?

This is one of the most frequent questions I am asked by advisers and my usual answer is, “well, the yield of Australin bonds is around x% so that’s pretty much what you should expect to receive”. I’ve pretty much accepted that my answer is roughly correct but never really tested its accuracy..until now!

Source: RBA, Morningstar

The above chart shows the 5 Year Australian Government Bond yield from the start of 1995 to August 2006 (red line), and the 5 year forward return of the UBS Composite index from each date (blue line). So the last blue data point at 31 August 2006 is in the annualised return of the UBS Composite index from 31 August 2006 to 31 August 2011. As the chart shows, the correlation is quite strong and the 5 year Australian bond curve does in fact appear to be a reasonable estimate of the bond market return.

The actual difference between he 2 lines is around 50bps. To make sense of this difference there’s two obvious reasons. Firstly, the UBS Composite index contains a little over 20% invested in less than AAA-rated securities so you would expect a return premium due to this (assuming the credit risk more than compensates the defaults). Secondly, the duration (and average maturity) of the index is different to a 5 year bond so this would also create a difference…although I thought the index was lower so I would expect the longer duration bond to provide a higher return in a time period of declining yields.

Anyway, for a 5 year period the bond yield does appear to be a reasonable proxy for future returns on the bond market. As at today, 5 year bonds are yielding around 3.75% so it looks like an investment in a diversified portfolio of investment grade bonds should provide not much over 4%pa over the next 5 years.

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