As we outlined in a recent commentary by Roger Aliaga-Díaz, Vanguard’s chief economist for the Americas and head of portfolio construction, investment-grade bonds can be a shock absorber when equities fall. 

“In the current climate—featuring a rise in inflation, reduced bond buying by the Fed, and more fiscal spending on the way—rising rates can actually lead to higher total returns from bonds if your investment horizon is longer than your bond portfolio duration,” said Ian Kresnak, a Vanguard investment strategy analyst. 

Government bond investors are exposed to two types of risk from interest rate movements: 

• Reinvestment risk 
  When yields are falling, investors reinvest cash flow from bond coupon payments at lower rates, reducing the yield component of future total returns. On the other hand, in a rising rate environment such as the one we're in now, they can reinvest cash flow at higher rates, increasing the yield component of future total returns. 

• Market price risk 
  The market price of a bond is determined by discounting future cash flows at the current market interest rate. Falling interest rates make a bond's future coupon payments worth more and, by extension, increase its current market price, and rising rates make a bond's future coupon payments worth less, decreasing its current market price. How much more or less is determined by the time until the bond reaches maturity. The future cash flow of a bond maturing in 2 years will be affected much less by a change in interest rates than that of a bond maturing in 30 years. The standard yardstick to measure this sensitivity of a bond's market price to a change in interest rates is duration, expressed in years.

These relationships apply to individual bonds as well as bond portfolios, funds, and ETFs.   

Rising interest rates can be good for bond investors if their investment horizon is long enough. Figure 1 shows the effect of the investment horizon on a hypothetical investment in a bond maturing in 15 years that pays a coupon of 0.9% annually when interest rates are at 2%. The bond's weighted average Macaulay duration is 14 years. (Macaulay duration is the weighted average time to receive coupon interest and principal payments that would allow the investor to recoup the bond’s price from its cash flows.)  

It’s true that when the investment horizon is shorter than the bond’s duration, the decline in market price outstrips the benefit of higher yields on reinvested cash flow. As shown in Figure 1, over a period of 5 or 10 years, a rise in interest rates of 100 or 200 basis points results in a deterioration in total returns.  

When the investment horizon is longer than the bond’s duration, however, higher yields on reinvested cash flow outweigh the market price decline. Over a period of 15, 20, or 25 years, interest rate rises of 100 and 200 basis points result in an improvement in total returns.  

(The inverse is true for total returns when interest rates decline. For investment horizons shorter than the bond’s duration, total returns improve; for horizons longer than the bond’s duration, they deteriorate.) 

Change in expected annualized total return over various investment horizons for a given instantaneous change in interest rates

During the 27-month period between July 2016 and October 2018, U.S. Treasuries experienced a significant rise in yields across the curve. Using that period as the investment horizon, the yield of the 2-year Treasury note rose 226 basis points, and the yield of the 10-year Treasury note rose 165 basis points. 

The left-hand panel of Figure 2 shows the price, coupon, and total return for the Bloomberg US 1-3 Year Treasury Index over that period. As the index had a duration of 23 months—shorter than the 27-month period we looked at—higher coupon payments offset the market price declines. Although the market price of the index fell by an annualized 1.54%, additional annualized coupon payments of 1.56% resulted in an improvement of 0.05% in the index's annualized total return.

The right-hand panel of Figure 2 shows the same thing for the Bloomberg US Long Treasury Index. For its duration of 18.5 years, much longer than the period under review, higher annualized coupon payments of 2.61% were overwhelmed by the annualized market price decline of -8.16%, resulting in a deterioration of -5.27% in the index's annualized total return. 

To cite another, more extreme example, as shown in Figure 3, in the 4-year period between May 2003 and May 2007, short-term yields rose significantly: The yield on the 2-year U.S. Treasury increased 313 basis points. As the index at that time had a duration of 1.8 years, annualized coupon payments rose by 3.50%, more than offsetting the annualized market price decline of 1.32%. For this index over this time period, rising rates boosted the annualized total return by a hefty 2.31%.

Duration as a metric assumes a parallel shift in the yield curve, but such shifts are rare in practice. Even in the first example above, the increase was far from perfectly parallel. 

Let’s consider a long-duration bond index (like the Bloomberg US Long Treasury Index) during the same 2003‒2007 period we examined in Figure 3. Did it sell off as it did in the 2016‒2018 period? No, and the answer largely has to do with how the yield curve shifted. 

As shown in Figure 4, short-term rates rose dramatically over the period—the 2-year U.S. Treasury rose 313 basis points—driving the 2.31% annualized increase in returns for a short-term bond portfolio shown in Figure 3. The long end, however, moved much less. The 10-year U.S. Treasury yield rose 76 basis points, and the 20-year Treasury yield (the “key rate” closest to the duration of the bond index in question) moved just 9 basis points higher. As a result, the price decline for the Bloomberg US Long Treasury Index was not nearly enough to offset the coupon return, and the total return stayed positive for the period. 

“As monetary policy normalizes, it is not a given that shifts in the yield curve will be parallel,” said Mr. Kresnak. “And forecasting the yield curve is challenging—the front end is influenced more by monetary policy, while the longer end is driven more by economic growth and inflation expectations.”

"Rising rates are not all doom and gloom for bond investors," said Mr. Kresnak. "They should find some solace in rising rates if their bond portfolio is at least reasonably calibrated to their investment horizon."

Duration is key:

• For an investment horizon longer than the duration of a bond portfolio, a rise in rates will create short-term pain but long-term gain.

• For an investment horizon shorter than the duration of a bond portfolio, consider an adjustment to align the two more closely.