Can We Predict Bond Returns?

Posted by Denis Smirnov

One of my favorite sources of weekly analysis are “The Weekly View” pieces from RiverFront Investment Group. Their team came up with a number of really cool analytical frameworks and one of them is shown in Exhibit 1.  The basic idea is that the starting yield on a 10-Year Treasury bond is a very good predictor of its total return over the subsequent 10 years.  So if the yield today is 1.9% (as of 4/2/15) then we can expect our annualized return to be 1.9%, give or take a few basis points.

Exhibit 1 – RiverFront’s Bond Return Framework

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Intrigued by such a simple model, I decided to run my own numbers to see how it works and if I can glean any additional insights. The results of my admittedly more amateurish analysis are shown in Exhibit 2. The 10 Years panel recreates RiverFront’s chart with annual instead of monthly data. It shows strong correlation between starting yield and returns: R-square of 0.9 is quite high and there is a clear linear relationship. The next three panels drop the projection timeframes to 5, 3 and finally 1 year. As you can see in the correlation equations, the accuracy of return predictions declines for shorter periods. Visually, the datapoints exhibit more dispersion with the 1-Year panel spread all over the place.

Exhibit 2 – Forward Annual Returns Based on Starting Yield

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Source: FRED, Robert J. Shiller, Aswath Damodaran, PlanByNumbers

So what does it all mean for people buying bonds (or bond funds) today? The equations suggest that bond investors should expect to make roughly 1.6% over the next 10 years (Exhibit 3). Keep in mind that those are nominal returns before inflation, which could easily be higher than that and result in negative real returns. Five year projection is a little higher at 2.3% but comes with lower “accuracy” of 0.8.  I wouldn’t pay much attention to the shorter timeframes, especially the 1-year randomness.

Exhibit 3 – Projected Forward Returns on 10-Year Treasuries

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Overall, I would take these return projections with a grain of salt. One general takeaway is that bond investors should temper their expectations, which is not easy to do after a 30-year bull market.