What Happens to Bonds When Rates Rise?

Written by David Slegh, CFA, CAIA, FDP, Portfolio Manager

Author Note: This commentary is part of a multi-post series focused on understanding the role of bonds (fixed income) in balanced portfolios [1]. In part one of this series we reviewed the potential diversification benefits that bonds have provided for balanced portfolios. Here, we will review what happens to bonds during periods of rising rates.

As discussed in the first article, when interest rates fall, prices on existing bonds normally rise due to their relatively attractive yields. And, generally, the opposite is true. Over the past four decades, the general backdrop for fixed income markets has been that of falling interest rates.

Figure 1: Long-term trend of 10-year interest rates 

During this history, there have been brief periods of rising rates, ranging from rapid readjustments to methodical moves. A variety of undercurrents influenced the nature of each move in interest rates. For the sake of brevity, we will constrain our analysis to high level observations surrounding how one would expect fixed income to behave in each period, versus its actual performance during these moves.

To understand how bonds should ‘theoretically’ behave during a rising interest rate environment, there are two key fixed income terms that must be discussed: duration and yield.

Duration: a term used to measure the interest rate sensitivity of a single bond or portfolio of bonds; the longer the duration, the more sensitive the bond or portfolio of bonds

By way of example, a duration of 5 indicates that for every 1% change in interest rates, the bond’s price could be expected to change by 5%. If rates go up, the price will drop by 5%. The reverse also applies and falling rates would result in the bond price rising by 5%.

Yield: compensation received for owning a firm’s credit risk; higher risk bonds tend to pay higher levels of income

A bond’s yield reflects the compensation (interest rate) the holder receives for owning the bond. In a rising interest rate environment, the hope is that the yield received can offset any losses experienced from the price decline of the bond, which is impacted by its duration.

It is important to note, there are a variety of other components that influence the price of a bond, such as credit ratings, yield spread, etc. However, for the purpose of this discussion we will focus on the basics of duration and yield.

Figure 2 shows the duration (blue line) and yield (orange) of the Bloomberg Barclays US Aggregate Bond Index over time. Yields have varied greatly, ranging from 16%+ (back in the 80’s) to the most recent reading of 1.32%. Duration of the index, likewise, has experienced significant variations over time, ranging from 4 during the height of the 2008-2009 financial crisis, to a most recent reading of 6.7.

Figure 2: Chart of duration and yield of the Bloomberg Barclays US Aggregate Bond Index over time

For simplicity’s sake, if we temporarily assume that interest rates and spreads remain stable, we could graph the yield expected to be received (yield) per unit of interest rate risk (duration).

Figure 3: Compensation received per unit of interest rate risk

In Figure 3, you can see that a current owner of fixed income has a dramatically different return per unit of risk profile compared to other points throughout history. For reference, a value below 1 on this chart would represent a scenario where a 1% change in interest rates could theoretically offset the annualized yield of the index.  In other words, bond holders are not receiving as much compensation today for the same level of risk.

Takeaway #1: Compensation (yield) received per unit of interest rate risk has varied greatly over the history of fixed income markets.

This raises the question, why would someone choose to own something where the odds may be stacked against them? The answer lies within the diversification benefits that fixed income has provided during previous periods of equity market volatility (where interest rates also fell). Author’s note: Please see article number #1 in this series for more information on fixed income’s diversification benefit even during periods of rising rates.

An additional ray of hope for fixed income investors rests within its actual behavior during the periods of rising interest rates. From a mathematical standpoint, many of these rising rate periods would have been expected to result in losses. However, improving economic backdrops and liquidity re-entering the market (i.e., compression of spreads) along with other various factors, resulted in dramatically different outcomes where bonds performed reasonably well despite the rise in rates.

For example, using end of month information, since 1970, there have been nine instances of significant upward moves (yields rising by +150 bps or 1.5%) in the 10-year Treasury rate. Only three of these moves resulted in fixed income incurring losses of greater than 1% (as measured by the Bloomberg Barclays US Aggregate Bond Index). While the limited number of observations pose a hindrance to drawing any significant conclusions, the fact that bonds were able to hold their own, roughly two-thirds of the time, should provide some solace for fixed income investors.

Takeaway #2: Fixed income’s performance during periods of rising rates has fluctuated over time, in part due to the temporary nature of each move (higher in interest rates). Drawing any significant conclusions from these is a dangerous game.

In conclusion, the risk reward spectrum for bonds is dramatically different today compared to the past. And while rising rates tend to provide a headwind for fixed income markets, it would be premature to assume that losses are all but guaranteed.

In subsequent parts of this series, we will delve into the implications of fixed income on balanced portfolios, followed by some potential tools that could be used to complement portfolios should we face a new regime of perpetually rising interest rates.

 

[1] For purposes of this article, balanced portfolio will be used as a term for any blended combination of equities and fixed income used in order to dampen volatility.CFA® and

Chartered Financial Analyst® are registered trademarks owned by the CFA Institute.

CAIA® is a registered certification mark owned and administered by the Chartered Alternative Investment Analyst Association.

FDP® is a registered certification mark owned and administered by the Financial Data Professional Institute.

Disclosures

The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market.

An investor cannot invest directly in an index. An index’s performance does not reflect the deduction of transaction costs, management fees, or other costs which would reduce returns. The index performance results provided in this presentation represent past performance and are not a guarantee of future performance. For additional information regarding these indices, please refer to the sponsor websites at www.bloombergindices.com and www.standardandpoors.com.

Asset allocation or diversification does not ensure a profit or protect against a loss.

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