Rate rises and bond returns: It’s all relative
Investment grade bonds, as measured by the Bloomberg U.S. Aggregate Index, experienced negative total returns in 2021.1 That’s certainly a rarity for this market that, despite persistent fears of rising rates and bond bubbles, has still had so few negative calendar-year returns in the last three decades you could count them on one hand.2 Rates rose enough to eat through the low yield on bonds to start the year, and as we all know, when rates go up, bond prices go down.
Now, with the market pricing in five more 25-basis-point hikes in the federal funds rate over the next 12 months3, many are naturally asking why they would want to hold bonds when we know interest rates are going up. As it turns out, the answers lie within the question, and they are three-fold, so let’s take them one by one.
With rate hikes already priced in, what will drive bond prices moving forward?
To begin, the market is already pricing in five rate hikes over the next 12 months. But that’s already in the price! Indeed, it’s a key reason why bond returns, especially short maturity bonds, were negative in 2021.
Going forward, what will drive bond prices one way or the other is not the U.S. Federal Reserve (Fed) delivering precisely on those expectations. Rather, bonds prices will be driven by what the Fed delivers relative to those already built-in expectations … and where further expectations stand a year from now. With the Fed already guiding that it will take a measured approach and likely only increase in 25-basis-point increments to start, that’s not a lot of room for upside surprise—and plenty of room for a pause or two that leads to a lower-than-expected number of hikes over the coming months. This is likely a good thing for bond returns, even if the Fed funds rate is higher 12 months from now than it is today.
The role of bonds as a diversifier
That leads into the second element of the question that begs an answer. We all know rates are going to be higher over the next year … right? Well, that certainly is the market expectation, and when it comes to the Fed funds rate, I would definitely not disagree that it is highly likely. But what if we’re all wrong?
That last question is arguably the very reason bonds have ever and continue to merit a material role in most long-term investors’ portfolios. In a world where inflation rolls over and economic growth doesn’t live up to expectations—whether because the economy collapses of its own accord or due to some exogeneous event (are you sure how the Ukraine-Russia saga is going to play out?)—we believe there is no more reliable source of positive returns than high quality bonds to diversify and mitigate losses as equities inevitable take a hit from their historically high valuations.
Interest rates don’t move in lockstep
Finally, investors must always remember that when we say interest rates are going up, it really matters which interest rates we’re talking about, because they don’t all move in lockstep. We need only look at the fourth quarter of 2021 as an example.
Yes, most rates in the U.S. went up and the 2-year part of the Treasury yield curve experienced some of the highest upside volatility we’ve seen in decades. But 30-year bond rates were down! Most bond portfolios are spread across the curve in terms of their exposure and still experienced negative returns, of course—but if history is any guide, as the Fed gets further and further into its hiking cycle, more and more of the curve will fail to move upward with changes in the Fed funds rate. Indeed, historically, long-end rates often start to come down and drop below short-end rates. This leads to the possibility of positive bond-price returns, even in the face of a hiking central bank.
The bottom line: Changes in expectations drive markets
So, while investors are right to be watching the Federal Reserve, inflation and the future of policy, we have to keep in mind that investment markets move based on changes in expectations, not the realization of what is already expected.
When it comes to bonds, that change in expectations that has occurred over the last few months has been admittedly a painful one for bond-heavy investors, but the benefit of that pain of the past is a brighter outlook for the future. Yields today are higher, and the market is pricing in significantly more hikes, which just creates more room for upside surprise in bond returns should expectations ebb. Perhaps most importantly, this means extra room for upside returns that could come when balanced investors need it most.
Ultimately, this is why we continue to believe in holding bonds as a key diversifier in investment portfolios. Because what if we’re all wrong?
1 Source: Bloomberg.
2 1994, 1999, 2013, 2018 and 2021.
3 Source: Bloomberg as of 2/9/2022.