Editor’s note: This is a first in a regular series on the economy and investing from Egan Ludwig, vice president of Waycross Investment Management in Bellingham.

In late 2008/early 2009, Treasury interest rates reached lows not seen since the 1940s. Once confidence began to inch its way back into investor’s minds, rates began to increase into the middle of 2009. Since then, rates have slowly moved back down to extremely low levels. What does this mean for investment portfolios going forward? To be more precise, what does this mean for bond returns? For this analysis, we’ll use the SBBI Intermediate Term Government Bond Index.

Interest rates fell from 13.96 percent at the end of 1981 to 2.42 percent at the end of 2009. Low risk, intermediate term government bonds returned a remarkable 8.5 percent per year during this period. Now interest rates have little downside left, but interest rates could stay very low for a long time. This is likely to result in bond returns that will be substantially lower than what we have experienced over the past 20 to 30 years. Investors need to adjust their expectations for future returns based on this new reality.

Learning from the past

Looking in the past at periods where interest rates were initially similar to where they are today may provide some guidance into future bond returns. For this analysis, we’ll look back at two similar interest rate environments, with varying economic backdrops.

The first period starts at the end of 1934 when yields on intermediate term government bonds stood at 2.49 percent. During the next 30 years interest rates fluctuated between 0.5 percent and 4 percent. The bonds returned 2.6 percent per year during this period. The economic backdrop began in the Great Depression and remained difficult until the latter part of the 1940s. Significant economic growth started in the ‘50s.

The second period started at the end of 1952 when yields on intermediate term government bonds stood at 2.35 percent. The next 30 years saw interest rates fluctuate between 1.72 percent and 13.96 percent. The bond market returned 5.2 percent per year during this period. This period began with robust economic growth that tailed off as inflation began to infect the economy in the 1970s. Note that the return on these bonds during 1982 (+29.1 percent), the last year of this period, had a significant positive impact on the average of 5.2 percent/year.

Looking to the future

What will be the return from bonds over the next five to 10 years? We simply cannot know the answer. However, investors should not expect returns equivalent to what we have experienced.

Investors also need to consider credit risks associated with owning bonds. In the past, Treasury bonds have been looked at as a risk-free asset. Over the last 30 years the intermediate term maturity of this risk free asset returned slightly more than 8 percent per year. Currently, investors are lucky to receive a 3 percent yield on Treasury bonds. The likelihood of the United States defaulting on its debt is incredibly low, even in an elevated debt environment.

However, corporate and municipal bonds, as well as international government bonds contain much higher credit risk compared to Treasuries. Given the current economic conditions it would not be surprising to see higher rates of default or restructuring in the near future within some of these sectors. Surprisingly, investors are not demanding significantly higher yields on these bonds. In fact, the yield to maturity on many intermediate term high quality corporate bonds is no more than the yield to maturity on equivalent maturity Treasuries. This happens very rarely.

Treasury bonds did an incredible job of counteracting stock market declines over the last 30 years. For instance, while stocks declined nearly 38 percent in 2009, Treasury bonds returned more than 10 percent. Looking forward, stocks will continue to move in their usual volatile fashion, but bonds will likely return much less as there is simply little room for yields to move to the downside. Whether it’s low interest rates or increased credit/default risk on various types of bonds, investors should be looking for other ways to diversify their portfolio if volatility is a major concern over the short run.

Egan Ludwig, CFA, is vice president of Waycross Investment Management in Bellingham. Reach him at Egan@waycross.com or 360.671.0148.