What higher rates for longer could mean for bondholders

The recent rise in rates has been hard on bondholders

Globally coordinated policy responses to generationally high inflation have pushed down bond returns across all major fixed income markets. In the United States, where the Fed lifted short-term interest rates from near zero to well above 4% last year, the total 2022 return from investment-grade bonds was –13%, as measured by the Bloomberg U.S. Aggregate Bond Index. Comparable bonds outside the U.S. didn’t fare much better, returning –10%, as measured by the Bloomberg Global Aggregate ex-USD Index Hedged. Long-duration U.S. Treasuries—one of the best-performing areas of the bond market over the prior decade—were particularly hard hit in 2022, returning –29%.

The silver lining: Higher expected returns over the long term

“Bond investors have been plagued over much of the past decade by historically low returns,” Vanguard investment strategy analyst Ian Kresnak said. “And the recent sell-off was especially hard to stomach for investors nearing retirement or those already in the decumulation phase. But given the rise in interest rates, they can now reinvest cash flows in bonds with higher coupons.”

The first figure shows the brighter outlook, as a $100 investment in U.S. bonds made on December 31, 2021, has a median projected value in 10 years’ time of $122. Aggressive interest rate hikes that began in March 2022 have dragged down bond prices, but they’ve improved the outlook for fixed income returns. Because of higher starting yields, a $100 investment in U.S. bonds made on June 30, 2023, would have a median projected value in 10 years’ time of $133, or about 9% higher.

Where rates may be headed

Some financial market commentators say fixed income is looking attractive now because the Fed is nearing the end of its hiking cycle.

“We would expect rates to remain elevated in restrictive territory for some time,” Hirt said. “That’s backed up by the ongoing resilience we’re witnessing in the labor market, housing, and consumer spending, but our outlook expects the largest policy adjustment to be behind us.”

How to invest in this environment

On the surface, a tilt toward short-term fixed income securities such as 3-month U.S. Treasury bills might seem to make sense given their attractive yields at the moment. But for investors with any sort of meaningful time horizon, the high returns on such securities could prove fleeting. Their starting yields say much less about how they will perform over the long term than do the starting yields of longer-term bonds because their coupons reset much more frequently. (Short-term bonds also tend to have a higher correlation with equities, making them less of a risk diversifier than longer-term bonds.)

That difference in return predictability over the long term is illustrated in the next figure, which shows the relationship between the starting yield and future 10-year annualized returns for 3-month Treasury bills and 10-year Treasury notes.