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.
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:
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