By Ian Kresnak, Investment Strategy Analyst, Vanguard
After a decades-long bull market, bonds have come under pressure. Yields hit all-time lows during the Covid-19 recession, but rose as the economy rebounded and some anticipate they may climb higher with the central banks in developed economies reducing their bond-buying programmes and the prospect of further fiscal spending. Make no mistake, though—bonds still merit inclusion in a broadly diversified portfolio.
In the current climate—featuring a rise in inflation, reduced bond buying by central banks, including the Federal Reserve and more fiscal spending on the way—rising rates can actually lead to higher total returns from bonds if your investment horizon is longer than your bond portfolio duration.
Government bond investors are exposed to two types of risk from interest rate movements:
These relationships apply to individual bonds as well as bond portfolios, funds and ETFs.
Rising interest rates can be good for bond investors if their investment horizon is long enough. Figure 1 shows the effect of the investment horizon on a hypothetical investment in a bond maturing in 15 years that pays an annual coupon of 0.9% when interest rates are at 2%. The bond’s weighted average Macaulay duration is 14 years. (Macaulay duration is the weighted average time to receive coupon interest and principal payments that would allow the investor to recoup the bond’s price from its cashflows.)
It’s true that when the investment horizon is shorter than the bond’s duration, the decline in market price outstrips the benefit of higher yields on reinvested cashflow. As shown in Figure 1, over a period of five or 10 years, a rise in interest rates of 100 or 200 basis points results in a deterioration in total returns.
When the investment horizon is longer than the bond’s duration, however, higher yields on reinvested cashflow outweigh the market price decline. Over a period of 15, 20 or 25 years, interest rate rises of 100 and 200 basis points result in an improvement in total returns.
(The inverse is true for total returns when interest rates decline. For investment horizons shorter than the bond’s duration, total returns improve; for horizons longer than the bond’s duration, they deteriorate.)
Figure 1: Rising rates can be a good thing
Change in expected annualised total return over various investment horizons for a given change in interest rates
Note: The illustration is on a hypothetical investment in a bond maturing in 15 years that pays a coupon of 0.9% annually with interest rates at 2% and assumes a duration of 14 years.
During the 27-month period between July 2016 and October 2018, US Treasuries experienced a significant rise in yields across the curve. Using that period as the investment horizon, the yield of the 2-year Treasury note rose 226 basis points, and the yield of the 10-year Treasury note rose 165 basis points.
The left-hand panel of Figure 2 shows the price, coupon and total return for the Bloomberg US 1-3 Year Treasury Index over that period. As the index had a duration of 23 months—shorter than the 27-month period we looked at—higher coupon payments offset the market price declines. Although the market price of the index fell by an annualised 1.54%, additional annualised coupon payments of 1.56% resulted in an improvement of 0.05% in the index’s annualised total return.
The right-hand panel of Figure 2 shows the results of the same analysis for the Bloomberg US Long Treasury Index. For its duration of 18.5 years (much longer than the period under review), higher annualised coupon payments of 2.61% were overwhelmed by the annualised market price decline of -8.16%, resulting in a deterioration of -5.27% in the index’s annualised total return.
Figure 2: The difference duration made to total return in a rising rate environment
Notes: The residual change refers to the component of total return not explained by price or coupon return. This is commonly known as ‘roll return’ and includes the effects of duration and convexity. Convexity is the sensitivity of duration (change in a bond’s price for a given change in interest rates) to a change in interest rates. It describes the tendency of bond prices to rise more than implied by duration for a given decrease in interest rates, and vice versa. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Sources: Bloomberg and Vanguard.
To cite another, more extreme, example as shown in Figure 3, in the four-year period between May 2003 and May 2007, short-term yields rose significantly: The yield on the two-year US Treasury increased 313 basis points. As the index at that time had a duration of 1.8 years, annualised coupon payments rose by 3.5%, more than offsetting the annualised market price decline of 1.32%. For this index over this time period, rising rates boosted the annualised total return by a hefty 2.31%.
Figure 3: Larger rises in rates resulted in greater increases in coupon payments for short-term bonds
Note: The residual change refers to the component of total return not explained by price or coupon return. This is commonly known as ‘roll return’ and includes the effects of duration and convexity. Convexity is the sensitivity of duration (change in a bond’s price for a given change in interest rates) to a change in interest rates. It describes the tendency of bond prices to rise more than implied by duration for a given decrease in interest rates, and vice versa. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Sources: Bloomberg and Vanguard.
Duration as a metric assumes a parallel shift in the yield curve, but such shifts are rare in practice. Even in the first example above, the increase was far from perfectly parallel.
Let’s consider a long-duration bond index (like the Bloomberg US Long Treasury Index) during the same 2003‒2007 period we examined in Figure 3. Did it sell off as it did in the 2016‒2018 period? No, and the answer largely has to do with how the yield curve shifted.
As shown in Figure 4, short-term rates rose dramatically over the period—the two-year US Treasury rose 313 basis points—driving the 2.31% annualised increase in returns for a short-term bond portfolio shown in Figure 3. The long end, however, moved much less. The 10-year US Treasury yield rose 76 basis points, and the 20-year Treasury yield (the ‘key rate’ closest to the duration of the bond index in question) moved just nine basis points higher. As a result, the price decline for the Bloomberg US Long Treasury Index was not nearly enough to offset the coupon return, and the total return stayed positive for the period.
Figure 4: Yields rose between May 2003 and May 2007, but not in parallel across the curve
Sources: Bloomberg and Vanguard.
As monetary policy normalises, it is not a given that shifts in the yield curve will be parallel. Forecasting the yield curve is challenging—the front end is influenced more by monetary policy, while the longer end is driven more by economic growth and inflation expectations.
Rising rates are not all doom and gloom for bond investors. They should find some solace in rising rates if their bond portfolio is at least reasonably calibrated to their investment horizon.
Ultimately a rise in rates will have different consequences depending on the alignment between the client’s investment horizon and the duration of their bond exposures. For multi-asset investors, it’s worth remembering that bonds play a stabilising role, acting as a buffer against equity market shocks. Taking tactical positions in fixed income markets can introduce extra risk to your portfolio, which is why Vanguard recommends investors stay diversified across the spectrum of investment-grade fixed income.
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