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What impact do higher interest rates have on future fixed income returns?

While rising interest rates have created short-term pain for fixed income investors, higher yields will be very beneficial for long-term returns.

10-year yields and subsequent bond returnsRising interest rates have been a source of short-term pain this year, but today’s much higher yields have significantly boosted the outlook for future fixed income returns.

While price fluctuations can have a material impact on short-term bond performance, longer-term returns are largely driven by the initial level of interest rates. This should be somewhat intuitive since the majority of bond portfolio returns over the long-term come from coupon payments. Over time, the performance impact of price fluctuations from rising or falling interest rates tends to be very modest. Provided a bond issuer doesn’t default on its debt obligations — historically a very low probability for high-quality bonds — investors who hold a bond to maturity would receive regular coupon payments over the life of the bond and receive their principal back in full when the bond matures, resulting in a total return about equal to the initial yield when the bond was purchased. Price fluctuations due to changing interest rates can have a notable short-term impact (as has been the case this year) but have little effect on long-term performance.

As shown in the chart above, 10-year returns for the Bloomberg Aggregate Bond Index, a proxy for the broad U.S. investment-grade fixed income market, have been highly correlated with the starting yield on 10-year U.S. treasury bonds. With long-term interest rates having now risen to levels unseen in nearly a decade, the outlook for bond returns over the next decade is more attractive than it has been in several years. In fact, with yields roughly double where they stood at the beginning of the year, expected returns over the next decade have essentially doubled as well.

The bottom line? It’s been a tough year for bond investors, but there are better days ahead.

Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all of the information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis nonfactual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.

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