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It’s a common preconception that rising interest rates are bad for bonds. While rate hikes are undoubtedly a headwind for fixed income assets, investors tend to overestimate the impact of rising rates and can overlook the benefits of holding bonds as part of a resilient and balanced portfolio.

Demystifying the misconception of interest rate hikes

The logic underpinning the negative sentiment towards bonds seems simple enough. As rates go up, bond prices fall. Duration, a commonly used measure of a bond’s sensitivity to interest rates, provides a rough rule of thumb that allows us to estimate how bonds may react to a specific change in interest rates. It suggests that if a bond has a duration of 7.5 years, roughly the same as the global aggregate bond index¹, a 2% increase in interest rates would translate to a 15% fall in capital values. Given the current historic low level of yields, it could take a long time to recoup such a large capital loss.

The reality is far more nuanced. To understand how bonds react to rising rates, history provides an excellent starting point. Since the early 1980s there have been five rate-hiking cycles in the US. This provides a wealth of data to track how markets have reacted in each instance.

First, it is important to note that interest-rate hikes have rarely happened without warning. In most cases, financial markets have already priced in at least part of the rate-hiking cycle before central banks start to hike rates. An exception was in 1994 when the market was caught off-guard by the US Federal Reserve (Fed)’s pre-emptive hike, and again in 2013 when the 10-year US Treasury yield doubled in six months during the ‘taper tantrum’.

Secondly, while bond yields have undoubtedly increased during rate hiking cycles, a rise in the US interest rate (the federal funds rate) does not translate into a one-for-one increase in US Treasury yields. Yields on short term bonds have tended to increase more, although they have usually risen less than the actual increase in the federal funds rate. At the longer end of the curve (10 years and out), the upward movement in yields has been far more muted as the purpose of rate hikes is to curb excess demand and suppress inflation, which in turn dampens inflation expectations. For example, during the recent 2015 to 2018 hiking cycle, although the federal funds rate increased by 2.25%, the 2-year rate rose by 1.68% and the 10-year rate rose by only 0.5% (see chart below).

The pace of rising interest rates is another aspect often overlooked by investors. When estimating the potential loss from rate hikes, investors often simply take the difference between the starting interest rate and the terminal interest rate, and then multiply it by the duration. However, rate hikes are a gradual process, often taking more than a few years to reach the terminal level. This is important because the slower the pace of rate increases, the more income fixed income assets can accrue to offset the potential losses from rising rates. For example, during the 2015 to 2018 rate-hiking cycle, it took a year before the Fed undertook its second hike and a total of 36 months for rates to be hiked by 225 basis points altogether (bps) (see chart above).

When all the above qualities are considered, a much more benign picture emerges for fixed income assets. The potential losses have tended to be smaller than feared, and the accumulation of income can play a critical role in offsetting the negative impact of rising rates. In fact, as the chart below shows, fixed income assets have often generated positive returns during hiking cycles.

1. As at 7 February 2022. Based on modified duration for the Bloomberg Global Aggregate Index. Source: Bloomberg

 

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
• Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.