Bonds have done so poorly this year that many investors wonder about still holding bonds. Others see a great opportunity in fixed income securities due to greatly increased yields. U.S. government bonds now yield over 4 percent; other developed countries exceed that. Non-government bonds yield even more.
While those who held bonds for portfolio stability have been disappointed, losing around 16% this year — yet yields are now available that haven’t been seen in over a decade. A painful drop of 21% in U.S. stocks is causing former bond investors who never liked stocks but needed more return, and so bought growth stocks as an alternative, to rethink their strategy.
Yet many are hesitant to take advantage of higher yields, fearing that more interest rate increases would negatively impact the value of their new bonds and bond funds even more. Bonds are subject to loss of principal when interest rates rise.1 That would be a mistake. Even if stock markets reach a cyclical low and go up, bondholders who maintain their positions can still enjoy a reasonable stream of return regardless whether yields rise.
Here is a smart way to think based on market prices: even if yields rise, investors planning for higher expected returns can be better off with investment grade bond positions as long as they maintain a consistent duration for their fixed income strategy that corresponds to their planning horizon.
Rising yields impact fixed income portfolios in multiple ways. On the one hand, bond portfolios with longer durations (the weighted average of the maturity of the bonds adjusted for reinvested cash flows) could experience more losses as interest rates continue to rise. On the other hand, new higher yields for investment-grade bonds ordinarily lead to higher expected returns.
This tradeoff is like a pit stop in a Formula 1 auto race. A pit stop causes the driver to fall back in time relative to competitors. However, fresh tires may help that driver to outperform and still win if enough laps are left to catch and pass the leader.
Exhibit 1: Recovery Race
Growth of a $100,000 fixed income allocation with a five-year duration
For illustrative purposes only. Fixed income securities are subject to increased loss of principal during periods of rising yields. Data presented are based on mathematical principles, are not representative of indices, actual investments, or actual strategies managed by Professional Financial, and do not reflect costs and fees associated with an actual investment. Growth of wealth assumes a constant duration and flat yield curve for simplicity. For Scenario 2, the approximate 15% drop in value shown in year 0 is based on a hypothetical yield increase from 1% to 4%, causing an immediate decline in value. The drop in value can be approximated by multiplying the assumed five-year duration by the yield increase.
Exhibit 1 illustrates this point with two $100,000 fixed income allocation scenarios, both with a five-year duration. Scenario 1 experiences only a constant yield of 1%. Scenario 2 suffers a sudden spike in yields from 1% to 4% on Day 1 and has an immediate drop in principle value to a little over $86,000, much like occurred this past year.
However, Scenario 2 now benefits from a higher yield that not only accelerates recovery but allows long-term outperformance: with a 4% yield rather than the previous rate of 1%, Scenario 2’s portfolio value overtakes Scenario 1’s within five years — a time horizon determined by the duration of Scenario 2’s bond portfolio.
Duration measures the sensitivity of a fixed income investment’s price to changes in interest rates. Generally, longer-duration bonds will have greater sensitivity to changing interest rates than lower-duration bonds. A five-year duration is what many clients of our firm have and this implies a reasonable expectation for them.
When faced with uncertainty, investors should focus on what is controllable. Research tells us that trying to outguess the market by just holding cash, waiting for the possibility of future yields to increase may not achieve long-term goals.2 Markets incorporate new information about interest rates and inflation before you can act on it profitably.3
Informed investors with a long-term horizon maintaining appropriate planning strategies, even with higher interest rates in the future, should still expect a successful investment experience and not worry.
1 The Bloomberg Global Aggregate Bond Index (hedged to USD) returned –12.1% from January 1, 2022, through September 30, 2022.
2 Doug Longo, “Bonds Deliver Positive Returns in July 2022,” Insights (blog), Dimensional Fund Advisors, August 12, 2022.
3 Wes Crill, “Light at the End of the Inflation Tunnel,” Insights (blog), Dimensional Fund Advisors, June 10, 2022; “Markets Appeared to Be Ahead of the Fed,” Insights (blog), Dimensional, June 16, 2022.