With a sustained rise in interest rates in the coming months a distinct possibility as of this writing, we thought now would be an opportune time to take a close look at some potential impacts of higher rates on clients’ fixed income portfolios. To do so, we compared the hypothetical five-year performance of the Bloomberg US Aggregate Bond Index under three different illustrative scenarios that could play out going forward: 1) rates remain unchanged; 2) rates rise abruptly; and 3) rates rise gradually (i.e., over three years).
Key takeaways for fixed income investors
A few of our main takeaways from this analysis were as follows:
- While abrupt rises in rates might lead to short-term drawdowns in fixed income portfolios, they can at times be desirable for longer-term investors, given opportunities to reinvest capital into higher-yielding bonds. In the “rates rise abruptly” scenario, a 1% rate rise results in a negative total return of -3.9% in year one, but could actually increase the cumulative total return over five years by 0.8% (from 7.4% to 8.2%).
- Gradual rate rises over time may produce only shallow portfolio drawdowns, with the potential for positive total returns over the longer term. In the “rates rise gradually” scenario, a 1% rate increase over the course of three years results in a neutral (flat) total return in year one, followed by expected positive total returns in each of the subsequent years.
- Initial portfolio drawdowns due to higher rates can often be recovered over time, primarily through yield and return “rolldown.” In the “rates rise gradually” scenario, the negative price impact from the rate rise in year one (-2.0%) is offset by the portfolio’s yield (1.4%), as well as a positive contribution from rolldown (0.6%). In years two and three, yield (which goes up as rates rise) and rolldown may outweigh the price impact from rising rates, potentially delivering positive total returns in those years.
Bond market performance under the three scenarios
As noted above, to gauge the potential return impact of higher interest rates on fixed income portfolios, we modeled the effect of three different hypothetical rising-rate scenarios — a 0.5% increase in rates, a 1% increase, and a 2% increase — on the Bloomberg US Aggregate Bond Index (a proxy for broad bond market performance) as of 30 September 2021 (Figure 1).
Figure 1
Roll baby, roll: The beauty of rolldown
It is worth further highlighting the potentially meaningful return impact that rolldown can have on fixed income portfolios. For example, rolldown may result in positive portfolio returns in some upward-sloping yield-curve environments. By way of illustration:
- September-end 2021 levels for 2-year and 3-year US Treasury yields were 0.28% and 0.51%, respectively.
- If a 3-year US Treasury were bought in September 2021 with a starting yield of 0.51%, and the levels of 2- and 3-year yields were the same a year later, then come September 2022, the 3-year Treasury would essentially be a 2-year Treasury but with a yield of 0.51% (versus 0.28%).
- As such, this may result in a ”rolling down the yield curve” and a potential price increase attributable to the 0.23% difference in yield between 0.51% and 0.28%.
Bottom line
Rather than necessarily being an automatic death knell for traditional bond portfolios, fixed income investors may actually benefit from rising rates under certain circumstances, depending on the pace at which rates rise and over what time period.
Related content
- Desperately seeking fixed income returns? by Brij Khurana and Amar Reganti (October 2021)
- Fixed income investors warily eye Congress and the Fed by Amar Reganti and Jitu Naidu (September 2021)
- Fed Chair Powell outlines taper timeline by Jeremy Forster (September 2021)