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Helen Guo, Niels K. Pedersen
Fixed income market returns during periods of rising interest rates are affected by both the magnitude of yield increases and their timing. They are also influenced by the initial level and shape of the yield curve and the composition of the investable universe. Both of these change over time. Therefore, a historical analysis of bond index returns during specific cycles of rising rates, such as the hikes of 1994 or those from 2002 to 2006, does not necessarily provide an accurate picture of prospective returns in future rising rate regimes. An analytical framework, which takes current yields and index durations properly into account, can help to more accurately identify the tradeoffs and prospective returns fixed income investors may face going forward. We use such a framework to analyze the potential performance of the most widely used fixed income index across a wide range of potential future yield curve scenarios. As part of the analysis we provide several rules of thumb for anticipating the impact of rising rates on fixed income returns. We also quantify the tradeoff between a reduction of duration risk and the associated opportunity cost in the form of lower carry. Our analysis highlights the fact that expectations for increasing yields in the future may not warrant a strategic shift into short duration fixed income portfolios or cash. In a steep yield curve environment, investors need to carefully assess how much yields will have to rise (and how fast) from their current levels to make it worthwhile to reduce duration risk in fixed income portfolios.
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