Will rising rates continue to weigh on bond returns?
Rising bond yields have weighed heavily on fixed income performance this year, resulting in broadly negative returns thus far. While further rate increases are certainly possible in the months ahead, the impact of higher yields on bond returns in the shorter run is likely to be more muted than they have been to this point.
There are two reasons for this. First, higher yields equate to a higher total return, all else being equal. Secondly, although rates are forecast to continue to rise, the upside from here is expected to be more limited. (Since December 31, the yield on the 13-week T-Bill has risen by 3%, while the 10-year Treasury yield increased by 1.9%.) A more restrained rate outlook would reduce the degree of additional downside in bond values.
By way of example, the chart above outlines the hypothetical subsequent one-year return of bond portfolios with various starting yields given a 0.50% or 1.00% increase in interest rates. As illustrated, a higher initial yield more effectively insulates a fixed income investor from the negative price impact of rising rates. In fact, a 0.50% increase from a starting yield of 4% (the approximate average yield across core-plus bond funds today) implies total return of about 2% over the following year. When the starting yield is lower, however, even a small increase in rates can completely offset the return from interest payments or even result in a negative one-year return as the yield is insufficient to outpace the decline in the bond’s price. A larger increase in yields (illustrated above as a 1% increase) creates an even greater performance headwind.
Bond market yields have risen sharply and in short order this year, as the Fed moved aggressively to tighten policy to fight inflation. While further rate increases are expected, today’s higher yields and a more restrained outlook for further rate increases should translate to a better return environment for bonds going forward — not only in the near term but prospectively over the coming decade, as we address in our accompanying piece.
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