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