Ben Carlson: Bonds' Five-Year Real Returns Reach a Historic Low; Higher Yields Improve the Return Outlook

Portfolio manager Ben Carlson argues that the Bloomberg Aggregate Bond Index (Agg) has experienced the most brutal market conditions in modern financial history, with real returns over the past five years hitting record lows.

Unlike the late 1970s, this cycle is unique because of nominal price declines. The Agg recorded its first-ever back-to-back negative years: down 1.5% in 2021 and 13% in 2022. The maximum drawdown reached nearly 20%, a phenomenon virtually unheard of in investment-grade intermediate-term bonds.

Carlson attributes the damage to a threefold problem: starting yields were too low, interest rates shot up in a hurry, and inflation was high. Together they created a perfect storm for poor bond returns.

The pivot is this: the average yield-to-maturity for the Agg is now approximately 5.5%, levels not seen in almost twenty years. While the historical relationship between starting yields and forward returns has weakened somewhat during this period — actual performance has even underperformed the yield expectation — higher coupon income is positioned to offset potential short-term price pain.

Carlson advises investors to avoid trying to predict macro developments. Instead, weigh risk and reward based on yield, credit quality, duration, and maturity. Cash yields are back up to 4%, U.S. government bonds yield more than 5%, and corporate bonds yield more than 6%.