Bond investors have been struggling with low yields for several years now, but the impact was more than offset by the steady gain in bond prices. With the market doing so well, investors were enjoying high total returns, so what was the difference if a fund was yielding 3% instead of 5%? But when bond prices begin to fall, the challenge of low yields becomes clear: there isn’t enough income to overcome even a modest sell-off.

Moderate Losses Can Eliminate Several Years’ Worth of Income

As an example consider the largest corporate bond ETF – the iShares Investment Grade Corporate Bond Fund (LQD). In early May, 2013, the fund had an SEC yield of 2.9%. As a result, investors only had only a modest yield to cushion any losses in the share price. The fund’s price did indeed fall in the months that followed, dropping nearly 9% by late June – meaning that investors lost the equivalent of about three years’ worth of income in less than two months. The same held true across all types of bond funds, even those with heaftier yields, such as high yield and emerging market bonds.

It doesn’t even require a down market for low yields to cut into investors’ total returns. Over the long term, the contribution to bonds’ total return from price is limited – which may have been lost on many investors in the bull market of 2010-2012. After all, bonds mature at a set par value, which leaves little room for longer-term upside. As a result, low yields significantly reduce bonds’ long-term return potential.

The Lessons of History

To gain a sense of just how much of an impact this can have, consider the period from 2010 to 2012. Bonds surged in popularity, and bond funds and ETFs hauled in billions of dollars in new assets. During this time, the Barclays Aggregate Bond Index returned:

2010: 6.54%

2011: 7.84%  

2012: 4.22%

Not bad, but keep in mind this was a period characterized by generally low yields. Comparatively, consider the returns the index delivered when yields were higher, in 1982-1993:

1982: 32.65%

1983: 8.19%

1984: 15.15%

1985: 22.13%

1986: 15.30%

1987: 2.75%

1988: 7.89%

1989: 14.53%

1990: 8.96%

1991: 16.00%

1992: 7.40%

1993: 9.75%

It’s true that note that rapidly falling rates played a part in the strong outperformance back in the 1982-1993 era, and that’s true. But remember, also, that yields on Treasuries spent that era in a range of 7% to 13%, with other market segments yielding even more than that. This is a far cry from the 1.5% to 3.5% yields that characterized the 2010-2012 – and that difference contributed to the difference between the bond market’s total returns in the two periods.

Note, also, that the higher yields of those earlier times provided the latitude for rates to fall a long way and goose total returns. (Prices and yields move in opposite directions.) Once yields fall near historical lows, there is less room for appreciation – another potential damper on total returns.

Higher Yields Mean More Opportunity

With all of this is background, it should be evident that there is a bright side to falling prices. When bonds sell off, investors have the opportunity to take advantage of the downturn by investing in bonds at their now-higher yields. While it can often be difficult to step up and buy when a market is trending lower, it also gives longer-term investors a chance to capitalize on higher yields and boost their portfolio income. Keep this in mind during the occasions when the bond market encounters turbulence in the years ahead.