From ETF.com:
As investors, we are constantly in the uncomfortable position of having to plan for the future with limited guidance from the past. Our job byline may as well be “uncomfortably stuck between past and future.” As a striking example, the relentless global march toward lower bond yields over the last 40 years is rather unlikely to persist in the decades to come. As zero to negative interest rates take hold around the world, many of the principles we use to navigate capital markets become increasingly less valuable (Brightman, 2016). The concept of a risk-free return, as a result, is teetering on the edge of relevance these days—quaintly unhelpful at best, wealth-destroying at worst.
Investors whose mandates include fixed-income allocations face some difficult decisions. Strategies designed to pick up incremental returns from mean reversion and that limit overexposure to both lower-quality creditors and large issuers have the potential to deliver a welcome edge in performance to both government and high-yield bond investors.
Bonds In Current Time
Although government bonds may provide investors near certainty of notional capital being returned, the risk of locking in long-term losses can also be a near certainty with negative real rates and the prospect of interest rates inevitably trending higher. Equating risk and volatility may be too simplistic to deal with the world we face today. In markets for government debt, favoring the a priori safe bet of high-debt-issuer countries, such as the United States, Japan, and developed European nations, can be far riskier to an investor’s wealth than interest-rate volatility or credit ratings may suggest. And although volatility can be an investor’s friend in credit markets, especially in high-yield corporates, by creating opportunities to trade against short-term mispricings, not all risk-taking is rewarded equally.
Improving Government Bond Portfolio Returns
A simple, yet robust, framework for forming reasonable long-term expectations is offered in the Research Affiliates expected returns methodology, publicly available on our website. As of October 31, 2016, our methodology suggests that global (ex-US) Treasury markets, measured by the Barclays Global (ex-US) Treasury Index, are expected to return between −1.9% and 2.3% over the next decade, with a central tendency of 0.2%, after inflation. The fact that the central tendency is positive is largely the result of expected currency movements. A weakening of the US dollar relative to global currencies is expected to add 1.3%, but no help is offered from the current real yield of −0.4% and the −1.1% expected return from current high valuations.
For many investors, an allocation to government bonds is the starting point for portfolio construction. When that allocation is expected to return nearly nothing over the next 10 years, the task of constructing a satisfactory portfolio is just that much more challenging. That said, a likely path for improving long-term potential returns in global government bonds is to be thoughtful and disciplined in allocating to country exposures.
Bond markets are built on the premise that issuers can borrow against the future, and some countries seem to be borrowing from a future far less rosy than thorny. With both high starting debt burdens and demographic trends associated with significant off-balance-sheet future borrowings combined with a reduced ability to spur growth, advanced economies such as Japan and the United States face major impediments to managing their ballooning national debt burden in the future. Yet, the debt of these countries dominates government allocations in traditional bond indices as a mechanical byproduct of their dominance in cumulative notional issuance....MORE
