Consensus forecasts continue to favor higher rates and low bond returns over the medium term. GMO, the Boston-based global investment firm, recently updated its 7-year real return forecast and projected a dire situation for most asset classes, including a projected -2.1% real return for U.S. bonds. Most investors understand the risk/return tradeoff expressed by stocks, but are not expecting a projected negative return coming from the less risky bond asset class represented by the iShares Core Total U.S. Bond Market ETF (NYSEARCA:AGG).
Capital market forecasts like these confound the asset allocation decision for risk-averse investors. Though these forecasts are always accompanied by significant disclaimers, it is not difficult to envision a scenario where the enormous post-crisis easing by central banks around the world finally takes hold and inflationary pressures force rates higher and bond prices lower. This could have severe consequences for bond investors near or in retirement.
Vanguard recently published its 15th annual study of its record keeper business covering $800 billion across 1.4 million participants in 401-k plans, How America Saves 2016. It shows that the fixed income allocation for 401-k investors from age 60 to 64 was 43%, from age 65 to 69 was 50%, and older than age 70 was 57%. This group of investors is in the pre-retirement and retirement phase and is usually risk-averse in order to stabilize their projected withdrawal stream of retirement income.
Clearly, the large fixed income allocations are targeted to reduce the volatility of their portfolios based on the historically lower expected volatility and drawdown of bonds compared to equities. The current low level of interest rates, however, almost assures that bond total returns over the medium term will be mathematically consistent with the current low yield levels of between 1.5% and 2% (See Davis, Aliaga-Díaz and Patterson) with the
