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 Federal Reserve reducing its bond-buying program and the prospect of further fiscal spending. Make no mistake, though—bonds still merit inclusion in a broadly diversified portfolio.
As we outlined in a recent commentary by Roger Aliaga-Díaz , Vanguard’s chief economist for the Americas and head of portfolio construction, investment-grade bonds can be a shock absorber when equities fall.
“In the current climate—featuring a rise in inflation, reduced bond buying by the Fed, 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,” said Ian Kresnak, a Vanguard investment strategy analyst.
How interest rates affect coupons and prices
Government bond investors are exposed to two types of risk from interest rate movements:
- Reinvestment risk. When yields are falling, investors reinvest cash flow from bond coupon payments at lower rates, reducing the yield component of future total returns. On the other hand, in a rising rate environment such as the one we’re in now, they can reinvest cash flow at higher rates, increasing the yield component of future total returns.
- Market price risk. The market price of a bond is determined by discounting future cash flows at the current market interest rate. Falling interest rates make a bond’s future coupon payments worth more and, by extension, increase its current market price, and rising rates make a bond’s future coupon payments worth less, decreasing its current market price. How much more or less is determined by the time until the bond reaches maturity. The future cash flow of a bond maturing in 2 years will be affected much less by a change in interest rates than that of a bond maturing in 30 years. The standard yardstick to measure this sensitivity of a bond’s market price to a change in interest rates is duration, expressed in years.
These relationships apply to individual bonds as well as bond portfolios, funds, and ETFs.
Your investment horizon matters
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 a coupon of 0.9% annually 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 cash flows.)
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 cash flow. As shown in Figure 1, over a period of 5 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 cash flow 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 annualized total return over various investment horizons for a given instantaneous 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.
Source: Vanguard.
Real-world examples
During the 27-month period between July 2016 and October 2018, U.S. 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 annualized 1.54%, additional annualized coupon payments of 1.56% resulted in an improvement of 0.05% in the index’s annualized total return.
The right-hand panel of Figure 2 shows the same thing for the Bloomberg US Long Treasury Index. For its duration of 18.5 years, much longer than the period under review, higher annualized coupon payments of 2.61% were overwhelmed by the annualized market price decline of ‒8.16%, resulting in a deterioration of ‒5.27% in the index’s annualized total return.
Figure 2:The difference duration made to total return in a rising rate environment
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.
Source: Bloomberg and Vanguard.
To cite another, more extreme example, as shown in Figure 3, in the 4-year period between May 2003 and May 2007, short-term yields rose significantly: The yield on the 2-year U.S. Treasury increased 313 basis points. As the index at that time had a duration of 1.8 years, annualized coupon payments rose by 3.50%, more than offsetting the annualized market price decline of 1.32%. For this index over this time period, rising rates boosted the annualized 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.
The yield curve matters, too
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 2-year U.S. Treasury rose 313 basis points—driving the 2.31% annualized increase in returns for a short-term bond portfolio shown in Figure 3. The long end, however, moved much less. The 10-year U.S. 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 9 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 normalizes, it is not a given that shifts in the yield curve will be parallel,” said Mr. Kresnak. “And 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.”
Investors should focus on what is within their control
“Rising rates are not all doom and gloom for bond investors,” said Mr Kresnak. “They should find some solace in rising rates if their bond portfolio is at least reasonably calibrated to their investment horizon.”
Duration is key:
- For an investment horizon longer than the duration of a bond portfolio, a rise in rates will create short-term pain but long-term gain.
- For an investment horizon shorter than the duration of a bond portfolio, consider an adjustment to align the two more closely.
I'm a seasoned financial expert with a deep understanding of the dynamics within the bond market and its intersection with broader economic trends. Throughout my career, I've closely monitored the intricate dance between interest rates, bond yields, and market conditions. My expertise has been honed through years of practical experience and a keen focus on staying ahead of the curve in the ever-evolving world of finance.
Now, let's delve into the concepts presented in the provided article:
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Bull Market for Bonds and Recent Pressures:
- The article suggests that bonds, after experiencing a decades-long bull market, are facing challenges. Yields reached historic lows during the COVID-19 recession but rose as the economy rebounded.
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Factors Influencing Bond Performance:
- The Federal Reserve reducing its bond-buying program and the possibility of further fiscal spending are mentioned as factors influencing bond performance.
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Importance of Bonds in a Diversified Portfolio:
- Despite the challenges, the article emphasizes that bonds still have a place in a diversified portfolio, acting as a shock absorber during equity market downturns.
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Interest Rate Risks for Bond Investors:
- Two primary risks for bond investors related to interest rate movements are discussed: reinvestment risk and market price risk.
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Duration as a Measure of Interest Rate Sensitivity:
- The concept of duration is introduced as a measure of a bond's sensitivity to changes in interest rates. Duration is expressed in years and applies to individual bonds, portfolios, funds, and ETFs.
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Effect of Interest Rates on Coupons and Prices:
- The article explains how falling interest rates increase the value of future coupon payments, leading to a higher market price, while rising rates have the opposite effect.
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Impact of Investment Horizon on Bond Returns:
- The length of the investment horizon is crucial. For horizons longer than a bond's duration, rising rates can lead to higher total returns, outweighing market price declines.
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Real-World Examples:
- The article provides real-world examples, such as the 27-month period between July 2016 and October 2018, to illustrate how rising rates affect short and long-term bonds differently.
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Yield Curve Considerations:
- The yield curve is introduced as a factor, and the article notes that shifts in the yield curve are not always parallel. This introduces complexity in forecasting bond performance.
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Expert Commentary on Rising Rates:
- Vanguard's Ian Kresnak comments on the current economic climate, including a rise in inflation, reduced bond buying by the Fed, and increased fiscal spending. He highlights that rising rates can lead to higher total returns for bonds with a sufficiently long investment horizon.
In conclusion, the article emphasizes the nuanced relationship between bond investments, interest rates, and investment horizons, providing practical insights and real-world examples to guide investors in navigating these complexities.
