"current yields are the best estimate of future returns"

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walkinwood
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"current yields are the best estimate of future returns"

Post by walkinwood » Wed Jul 29, 2015 10:28 pm

Where does this concept "current yields are the best estimate of future returns" regarding bonds come from?

And what does it refer to? Bonds held to maturity or bond funds? Long term, short term or intermediate? Corporate or treasury?

I've been seeing this in a number of places, but can't find a definitive source or study.

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SimpleGift
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Re: "current yields are the best estimate of future returns"

Post by SimpleGift » Wed Jul 29, 2015 10:35 pm

There are numerous studies showing the close correspondence between beginning yields of bonds and their actual forward returns over long periods. This first one is from Mr. Bogle's Financial Research Center and shows intermediate-term Treasury yields and their subsequent 10-year returns (R^2 = 0.91):
And this second study from Schwab shows the Barclays U.S. Aggregate Bond Index, with beginning yield-to-maturity plotted against subsequent 10-year total returns:
It's a fairly well-studied phenomenon over various historical periods and maturities of bonds, so I expect a Web search would turn up even more analyses, if you're interested.
Cordially, Todd

lack_ey
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Re: "current yields are the best estimate of future returns"

Post by lack_ey » Wed Jul 29, 2015 10:40 pm

It's talking about bond funds, usually. SEC yield, not current yield or TTM or something like that. For an individual bond held to maturity, the return you get is the yield to maturity. Less if there's a default.

It's for short-term, long-term, and intermediate, though be warned that the period over which this property roughly holds depends on the duration of the fund. Note that returns for any given year may deviate significantly from the best guess because the short-term change in price based on yield changes is highly random. And returns in the very long term are dominated by long-term trends in interest rates.

It's more accurate for Treasuries than corporates, especially high yield.

Looking at the post above, you can see that sometimes even this best guess is off by a decent amount.
Last edited by lack_ey on Wed Jul 29, 2015 10:41 pm, edited 1 time in total.

stlutz
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Re: "current yields are the best estimate of future returns"

Post by stlutz » Wed Jul 29, 2015 10:41 pm

Just to reference a couple of past threads:

viewtopic.php?t=155923

viewtopic.php?t=156508

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ogd
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Re: "current yields are the best estimate of future returns"

Post by ogd » Wed Jul 29, 2015 11:14 pm

It also stands to reason. With bonds all you get is the yield, and then you're done with it after a while. They don't have the "perpetuity" aspect of stocks, where a stock that has kept up earnings & dividends but has a huge problem on the horizon is going to be hit massively. Or a stock that stumbles upon the medicine of the decade and exceeds expectations massively.

If all you get is the yield, and considering that the market doesn't like to set yields far out of tune with what it expects to actually happen, then the yield is pretty much the center line of volatility (and not even much of it).
walkinwood wrote:And what does it refer to? Bonds held to maturity or bond funds? Long term, short term or intermediate? Corporate or treasury?
All of the above, save perhaps for the junkiest of corporate bonds which may behave much more like stocks. That is, defaults detract from yield-as-expectation, permanently.

walkinwood
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Re: "current yields are the best estimate of future returns"

Post by walkinwood » Wed Jul 29, 2015 11:36 pm

Thank you all.
I'll read the article and threads referenced.

longinvest
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Re: "current yields are the best estimate of future returns"

Post by longinvest » Thu Jul 30, 2015 7:47 am

The previously linked posts and charts only show you what happened within the very small amount of historical data available.

If you would also like to consider the fundamental nature of bonds and why there are significant limitations that make it impossible for any future return prediction to be precise, for a total-maket bond fund, I encourage you to read the following thread:

viewtopic.php?f=10&t=170335
The uncertain future return of a broad bond fund

Some people predict the future return of a bond fund using is its SEC Yield or average yield to maturity (YTM).

Using a fund's YTM as a prediction assumes that the fund will hold all bonds until maturity and distribute back the principal of maturing bonds to investors, in addition to coupons, until the fund's duration becomes 0 (all bonds have matured) and the fund is closed. This is not how a bond fund works!

A bond fund keeps a relatively constant duration. In simpler words, it reinvests the principal of maturing (or sold) bonds. To make an accurate prediction, one must predict the yield at which principal will be reinvested (unknowable in advance). Note that when the yield curve is steep, reinvestment yield is always higher than the fund's YTM. For all those investors worried about higher yields: higher yields imply a higher reinvestment yield, which eventually translates into a higher total return.

Accurately predicting the exact future return of such a complex bond fund as a Total Bond Market fund over any future period of time (1 day to 60 years) is simply impossible. In the short term (1 day), a change in the yield curve (unknowable in advance) dominates total return. In the long term (2 X duration and more), future reinvestment yields (unknowable in advance) dominate total return. In between, both factors impact total return.

Because bonds are contracts to pay precise amounts of money on specific dates (coupons, principal), assumptions about reasonable limits on yield movement allows the use of mathematics to compute a likely range of possible future total returns over a specific time period. But, this range is far from tight.

Now, don't interpret the above to mean that bond returns are completely unpredictable, that there is a possibility of a Bondageddon. Mathematics allow us to easily realize that the price volatility of an aggregate bond fund is limited, because the fund contains a significant amount of short and intermediate-term bonds. In other words, bonds are not stocks!

In summary, any precise broad bond fund return prediction (e.g. "expect SEC Yield") without an accompanying range or with a tight range is misleading.
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic/international)stocks/(nominal/inflation-indexed)bonds | VCN/VXC/VLB/ZRR

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