In our Vanguard Economic and Market Outlook for 2024: A Return To Sound Money, one of the key themes we explore is how the persistence of positive real interest rates will impact fixed income returns in investor portfolios.

Short term pain can lead to long-term gain. Nowhere has that pain been felt more over the last two years than in bond markets, where sharp rises in interest rates have led to a significant repricing of existing bonds ‒– and painful losses for bond investors.

Yet while the impact of interest rate increases can be felt immediately, the longer-term benefits of higher rates take time to play out. It may not seem like it now, but a higher rate environment should ultimately prove beneficial for bond investors, providing significant additional value through higher returns and higher levels of income that, if reinvested, should eventually more than offset the previous capital losses from the past two years. Looking ahead, our outlook for long-term bond returns has increased to levels not seen since the decade before the global financial crisis of 2008, when yields were last above 4%1.

Short-term pain for long-term gains

While we expect major central banks to start cutting policy rates from around the middle of next year, we expect short- and long-term rates to settle at higher levels than we became used to in the previous decade. The structural shift towards an era of positive real rates – an era of sound money -  will have profound implications for the global economy and financial markets. and is good news for bond investors.

To illustrate why, the chart below shows the hypothetical performance of a lump sum invested in a portfolio of bonds at the end of May 2021. The black line highlights the impact of interest rate increases on the value of the portfolio, with the brown line showing the hypothetical expected growth over the next ten years in the new higher rate environment. The green line shows the hypothetical performance of the same portfolio if rates had remained low.

As we have witnessed over the last two years, the sharp rate rises initially caused the bond portfolio to decline in value, resulting in significant losses throughout 2022. Yet, as bond yields have increased to their current levels, we can see that, over time, the portfolio recovers in value.  The improved return outlook helps replenish the previous capital losses (brown line), eventually providing higher cumulative bond returns to investors than they would have earned if rates had not increased in the first place (green line).

Rising rates mean higher returns for long-term investors

A return to sound money

Today, thanks to the significant increases in rates, the income portion of bond returns has grown markedly – which we expect will not only boost total long-term bond returns but also marks a shift in the contribution of bond income to total portfolio returns.

According to our latest forecasts, we now expect Canadian bonds to return a nominal annualized 4.3%–5.3% over the next decade, compared with the 1.4%–2.4% annualized returns we expected before the rate-hiking cycle began. Similarly, for global ex-Canada bonds, we expect annualized returns of 4.0%–5.0% over the next decade, compared with a forecast of 1.1%–2.1% when policy rates were low or, in some cases, negative.

Expected 10-year annualised asset class returns for Canadian investors2

A bumpy transition

This doesn’t mean volatility is behind us. Markets are eagerly anticipating rate cuts by central banks in 2024. A fall in rates will push up the price of existing bonds, which will benefit bond investors – but it’s unlikely to be a smooth transition.

Among the risks that could rattle bond markets is the unwinding of major central banks’ bond-buying programs, which could raise volatility, particularly at the longer end of the yield curve, by reducing liquidity and increasing the term premium demanded by investors. (The term premium is the additional yield required to compensate investors for the added risk of interest rate changes over a bond’s lifetime.)

Even though we expect major central banks to start gradually cutting rates from the middle of next year, short- and long-term rates will, in our view, settle at higher levels than we’ve become accustomed to in the past decade. While this will limit the potential gains from bond price increases, we believe the persistence of higher yields – a strong predictor of long-term bond returns – will ultimately benefit disciplined investors over the long run.

The bottom line
For bond investors, timing potential shifts in bond markets with asset allocation decisions is extremely challenging. It’s far better to focus on what investors can control – such as calibrating the duration of their bond portfolios to match their time horizons, which can help optimize investment outcomes while reducing exposure to interest rate and reinvestment risk.

The transition to a higher-for-longer rate environment has not been easy over the last few years. The good news is we’re nearing the end of this structural shift; which should ultimately provide a more solid foundation for delivering long-term bond returns.

The bottom line: Rather than a bane, the rise in interest rates is the single best development for investors in 20 years.

IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model® 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 the VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of December 31, 2021, and September 30, 2023. Results from the model may vary with each use and over time.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include US and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, US money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

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.

Performance may be calculated in a currency that differs from the base currency of the fund. As a result, returns may decrease or increase due to currency fluctuations.

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The information contained in this material may be subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc.

Certain statements contained in this material may be considered "forward-looking information" which may be material, involve risks, uncertainties or other assumptions and there is no guarantee that actual results will not differ significantly from those expressed in or implied by these statements. Factors include, but are not limited to, general global financial market conditions, interest and foreign exchange rates, economic and political factors, competition, legal or regulatory changes and catastrophic events. Any predictions, projections, estimates or forecasts should be construed as general investment or market information and no representation is being made that any investor will, or is likely to, achieve returns similar to those mentioned herein.

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1 Source: Vanguard calculations, based on data from Bloomberg, as of September 30, 2023. Details of our forecasted returns can be found in Vanguard’s Economic & Market Outlook 2024 page 18 [hyperlink].

2 Indexes used in Vanguard Capital Markets Model simulations: The long-term returns of our hypothetical portfolios are based on data for the appropriate market indexes as of December 31, 2021, December 31, 2022, and September 30, 2023. We chose these benchmarks to provide the most complete history possible, and we apportioned the global allocations to align with Vanguard’s guidance in constructing diversified portfolios. Asset classes and their representative forecast indexes are as follows: (Assets in Canadian dollars) Canadian aggregate bonds: Bloomberg Canada Aggregate Bond Index; Global ex-Canada aggregate bonds: Bloomberg Global Aggregate ex-Canada Index CAD Hedged; U.S. aggregate bonds: Bloomberg U.S. Aggregate Bond Index CAD Hedged; Canada credit: Bloomberg Sterling Aggregate—Credit Bond Index; U.S. credit: Bloomberg U.S. Credit Bond Index CAD Hedged; U.S. high-yield credit: Bloomberg U.S. High Yield Corporate Bond Index CAD Hedged; Emerging-markets sovereign debt: Bloomberg Emerging Markets USD Sovereign Bond Index—10% Country Capped CAD Hedged.