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Do Rate Hikes Always Result in Negative Bond Returns?

Summary

Do rate hikes always result in negative bond returns? The real world is a messy place, and other factors also influence fixed income returns—notably the reinvestment of coupon payments.

In March, the Federal Reserve raised the Fed Funds rate for the first time since 2018.  And both the Fed and market pundits forecast the central bank will raise rates another 6-7 times this year, raising the Fed funds rate by an estimated 162 basis points (from today’s 0.38% to 3% by year end).1  But does that mean rate hikes always result in negative bond returns?

Bond yields and bond prices move in opposite directions. This is a well-established tenant of financial theory.  But does this mean bond investors should automatically expect negative returns on their bond portfolios?

Let’s consider the evidence.

There have been seven rate hiking cycles since May 1983 whereby the Fed raised interest rates an average of 252 basis points.  Yet, despite an average 290 basis points in rate hikes, the Bloomberg Barclays US Aggregate Index returned an average 3.9% during these seven rate-hiking cycles. During the two most recent rate hiking cycles—from 2004 – 2006 and again from 2015 – 2018, the Barclays US Aggregate Bond Index rose 6.5% and 6%, respectively. In fact, bond returns were negative in only one rate-hiking cycle in the above table—the current one.

If bond prices and interest rates move in opposite directions, how can it be that bonds posted positive returns during these rate hiking cycles?  It is true that bond prices during the early stages of these rate hiking periods initially declined. However, those rate hikes also contain an important silver lining for long-term bond investors: higher rates mean higher yields on reinvested bond coupon payments.  This fact is missed in traditional yield-to-maturity (YTM) calculations often cited by financial professionals, which erroneously assume that a bond’s coupon payments are reinvested at the same interest rate as the underlying bond. Subsequently, portfolios that continue to hold bonds through rising rate environments are well-positioned to benefit over time from those same higher rates by reinvesting bond coupon payments and principle (upon maturity) into new, higher yielding bond issues.

But is it different this time?

These are some of the most dangerous words in investing. Maybe it is. It’s hard to tell; the future is always unknowable.  But we can look to the past as a guide. And here’s what market history has to tell us:

  • Rates were near zero at the beginning of the December 2015 – 2018 rate-hiking cycle, during which time the Bloomberg Barclays US Aggregate returned 6%.
  • The Fed funds rate was well below 1% at the beginning of the June 2004 rate-hiking cycle—a cycle that saw a staggering 17 hikes totaling 425 bps over 24 months during which time the Bloomberg Barclays US Aggregate returned 6.5%.
  • Even during the violent upheaval in interest rates from 1977-1981, a period when interest rates skyrocketed to 20%, the Bloomberg Barclays US Aggregate returned a staggering 16.2%.

 

Lessons for Investors

  • Maintain a long-term perspective. Negative returns are never a good feeling, especially on those parts of the portfolio (like bonds) that we expect to hold up in the face of market volatility. But similar to equities, a long-term perspective can pay big dividends for bond investors who remain diversified and reinvest bond coupon payments through rate hiking cycles.
  • Downward pressure on bond prices doesn’t necessarily equate to negative returns. Reinvestment risk can have a material impact—good or bad—on bond returns. While reinvestment risk over the past 40 years fixated on the negative—the prospect of reinvesting coupons at lower future yields—the reverse is now true. When rates rise, bond coupons are reinvested at higher yields, which can have a material impact on returns over time.
  • When in doubt, diversify. Removing bonds from a portfolio, any portfolio, should require an exceptionally high standard of evidence. Forgoing critically important diversification is never a decision to be taken lightly. In the current environment, arguments to exit fixed income fail to meet our standard for evidence. That said, the current environment argues for investor bond portfolios to remain diversified, of high quality (investment grade), and of short duration (e.g., less than 5 years).

We remain humbly committed to helping each investor we advise maintain an exceptionally well-diversified portfolio with a risk-appropriate allocation to high quality, short-term bonds. Please reach out to your advisor if you would like to review your allocations and see how your portfolio supports your comprehensive long-term financial plan.

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