Bonds in a Rising Rate Environment
by Daniel B. Berkowitz
The title of this note raises a provocative question that we see frequently written about in the financial press. Prior to the (presumably) forthcoming Federal Reserve interest rate hiking cycle, the question about the usefulness of bonds in portfolios addressed whether fixed income was relevant in our ultra-low interest rate world. Now, this question is being reconsidered in the face of upward pressure on interest rates, which, generally speaking, create capital losses for fixed income investments. It is this scenario that I will explore in greater detail.
Throughout this cover letter, I refer to “interest rates” to generally describe nominal yields on US government bonds. The specific interest rate increases that are being discussed in the press are short-term in nature and are controlled by the Federal Reserve (i.e., the Federal Funds rate). As of February 28th, and even under the current backdrop of the crisis in Ukraine, it still remains likely that the Federal Reserve will increase short-term rates beginning in March in an attempt to ultimately slow the current rate of inflation in the US. For example, the market is currently projecting short-term rates to rise from their current level of essentially zero to at least 1.5% by the end of 2022.¹
That’s quite an increase relative to where we are now, and reflects the strong action that the market expects is necessary for the Federal Reserve to quell inflation. These potential rate hikes beg the question posed at the beginning of this note, are bonds still relevant today in a world of rising interest rates?² The answer to this question is “yes” for a few reasons.³
The first, and most important, relates to the role that fixed income plays in a balanced portfolio. The fixed income mutual funds that PMA uses hold a wide variety of bonds including government bonds, corporate bonds, and in some cases, municipal bonds. Additionally, the majority of our fixed income allocations are of high-quality, meaning they hold bonds with investment-grade credit ratings from major credit ratings agencies.
The purpose of our fixed income allocation is to provide a diversification benefit to equities, which represent the growth engine of our portfolios. High-quality bonds serve as portfolio shock absorbers during times of equity market stress, which are very difficult to predict in advance. Even if we reduced fixed income allocations in anticipation of a potential environment of rising interest rates, we would be undermining the very role that bonds are intended to serve in our portfolios—it is unlikely that proceeds reallocated from bonds to some other investment (i.e., high-dividend-paying equities) would provide the same degree of downside protection when it’s needed most. With that said, even during periods of rising rates specifically, a high-quality fixed income allocation should still be expected to provide strong diversification to an equity exposure.⁴
The second reason we still believe it makes sense to hold bonds in a rising rate environment relates to our focus on long-term investing. The main apprehension that we see generally discussed is that capital losses accrue to bonds’ principal after an increase in interest rates. This is a legitimate concern, as bond prices move in the opposite direction of yields. In an ideal world, an investor could market-time his or her way around a series of interest rate increases. In practice, interest rates, like all other macroeconomic variables, are notoriously difficult to predict over the short-term, even for professional forecasters.⁵
Nonetheless, for an investor with a long-term horizon, this concern becomes less relevant. In fact, higher interest rates can even benefit fixed income investors. After interest rates rise, a bond will typically experience a short-term capital loss. But for investors with a sufficiently long investment horizon, a higher total return can ultimately be achieved by reinvesting income received from the bond at a now higher market interest rate—this principle applies to both individual bonds and to bond funds, which are in essence collections of individual bonds.⁶
Though the concept described above is a generalization, it is a powerful expression of why focusing on the long-term is important, both for fixed income and equity investments. From PMA’s perspective, we have maintained a bias towards shorter- and intermediate-maturity fixed income investments for risk control purposes for much of the firm’s history. As you know, we do not attempt to time the short-term direction of interest rates, though we’ve focused on keeping a shorter-maturity fixed income profile lately to mitigate both rising inflation and interest rate risk in particular. If you would like to discuss any of the above in more detail with your advisor, please do not hesitate to contact us.
¹ These expectations are gleaned from federal funds futures, which are interest rate derivatives. Specifically, federal funds futures are currently pricing in roughly an 80% probability that the target Federal Funds rate rises to at least 1.5% by the end of this year. Refer to: https://www.wsj.com/articles/bond-market-shakes-off-hefty-swings-in-sentiment-11646003578?mod=hp_lead_pos1.
² For the purposes of this note, I’ll also generalize about rising rates by assuming an equivalent increase in yields across the curve (known as a “parallel shift”). In reality, such parallel shifts are uncommon.
³ We do currently have a small, explicit allocation to high-yield (or lower credit quality) bonds in our portfolios. In most of the portfolios we manage with a fixed income allocation, the target high-yield allocation is 10% of the fixed income sleeve.
⁴ For example, during the last Federal Reserve hiking cycle (December 2015 – December 2018), US fixed income indexes containing high-quality bonds such as the Bloomberg US Aggregate Bond Index still had low or negative correlations with the S&P 500 Index.
⁶ The “sufficiently long investment horizon” that I refer to is a bond’s duration, or a bond fund’s weighted average duration. Duration is a statistic which can be used to approximate how bond prices are affected by movements in interest rates. If you are interested in a more detailed explanation of this concept, refer to this blog post from Vanguard: https://investor.vanguard.com/investor-resources-education/news/the-dynamics-of-bond-duration-and-rising-rates.