Are Rising Rates a Slap in the Face to Bond Performance?
Timely return of a loan makes it easier to borrow a second time.
— Chinese Proverb
The US Federal Reserve committed to raise interest rates in the face of rising inflation. In response, investors and financial media have been awash with predictions that bonds will underperform cash and that longer-duration bonds will underperform shorter-duration bonds. E.g. Headlines from Bloomberg, Morningstar, and Yahoo Finance:
The marketing departments of the big financial institutions, brokerages and investment houses have been trying hard to convince investors to switch to floating-rate strategies, collateralised loan investments, barbell strategies, and various company specific stock picks to benefit from rising rates.
As these stories are increasingly gaining attention, it is a good time to look at the relationship between rising rates and the nature of bond performance. Research by Nobel-winning economist Eugene Fama showed that there was no conclusive evidence on the role of the Fed versus market forces in the long-term path of interest rates. We should always keep in mind that the Fed is merely one of many central banks or participants in a large global financial ecosystem.
Bonds Do Better Than Cash in Rising Rate Environments
Using over 30 years of FTSE World Government Bond Index data spanning across multiple countries, the diagram below shows the relation between the change in the federal funds rate in a given year and the returns on government bond indices in excess of cash over the following year. You will notice that there is no relationship between bond returns and changes in rates. In fact, during rising rate environments, there were very few instances where bonds were negative the following year.
If you look at the excess returns of bonds over cash, you will see that whether or not interest rates rose, bonds still performed.
Should I Hold Short Duration Bonds in a Rising Rate Environment?
The difference in performance between long duration bonds (bonds with 7 to 10 year maturity) and short duration bonds (bonds with 1 to 3 year maturity) were measured in rising rate environments; these were illustrated in the following diagrams. Contrary to popular belief, you can see that long duration bonds still continue to perform as expected even in rising rate environments. Although it may seem logical to assume so at first, long duration bonds do not necessarily underperform when rates rise.
The important takeaway here is that there are no reliable relationships between bond returns and changes in the interest rate. There is no need to hold cash or switch to other fancy sounding investments just because rates are rising. The best way to achieve a return during all types of rate environments is a systematic bond strategy which can dynamically vary its duration and currency allocation based on current term spreads across yield curves. This is what we employ in many of your portfolios.
If you feel worried about rising rates, or just need a second opinion on your finances, come chat with us.
