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Will rising rates continue to weigh on bond returns?

Rising interest rates are always a headwind to bond performance, but higher starting yields can serve as a meaningful positive cushion that offsets falling prices.

Higher yields cushion the impact of rising ratesRising 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.

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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