Rising rate environments can challenge even the most sophisticated fixed income investor. Considering the current market juncture and its potential impact on liquidity management and fixed income portfolios, we believe analyzing historical rising rate periods can provide a valuable perspective to investors. We make these key observations:
- When interest rates rise, the market value of previously issued fixed coupon bond holdings will fall as investor demand shifts to new, higher-yielding bonds. But not all securities are created equal.
- Bonds with shorter maturities, floating interest rates and/or higher yields should experience less dramatic price declines, and even potential price increases if demand for them outpaces supply available.
- During periods of rising interest rates and stable credit conditions, investors shortening duration could benefit from not only better overall total returns but also, and possibly equally importantly, reduced volatility in their portfolios.
This paper examines the risks of – and opportunities in – rising rates. We explore prior rising rate periods, using indexes as proxies to illustrate how various fixed income strategies performed and outline strategies and solutions to better insulate a short-term fixed income portfolio in a rising rate environment.
Analyzing recent interest rate cycles
Investors anticipating a reduction of monetary stimulus may benefit from a review of the four major periods of monetary tightening and rising interest rates that occurred over the last 30 years, as the direction of interest rates is a critical determinant of the performance of fixed income securities. As rates fall and rise in cycles, bond markets can turn from boom to bust, creating or hurting investment value in a sometimes unpredictable fashion. When interest rates fall, previously issued fixed-coupon securities will typically increase in market value. When rates are rising, those same securities will decrease in value.
Exhibit 1: Rising Rate Periods Over the Last 30 Years
All four rising rate periods saw both U.S. Federal Reserve target rate (fed funds) and U.S. Treasury (UST) yields increase. In periods 2 and 3, the markets were able to anticipate and price in the tightening of monetary policy before the fed funds target rate moved. This is evidenced in the rise of UST yields roughly nine and 12 months prior to monetary policy tightening in each respective period. The 1994 tightening caught markets off guard, as both the fed funds target rate and UST yields began to move higher at about the same time. And, in period 4, the low-growth, low-inflation environment led the U.S. Federal Reserve (the Fed) to start the cycle extremely slowly with only one hike per year in 2015 and 2016, muting initial yield changes on term Treasuries, before speeding up the pace in subsequent years, causing yields to rise further out on the yield curve (Exhibit 1).
While the precise start and end points of a rising rate period may be open to debate, we define the start as the point at which 10-year UST yields begin to rise, and the end when the Fed stops increasing the fed funds target rate.
A rising rate period can be characterized by its starting conditions (e.g., yield levels) and the pace at which rates rise. Lower starting yields and/or a faster-paced rate rise will typically lead to worse performance for longer-duration fixed income assets vs. periods where starting yields are higher and/or the pace at which rates rise is slower.
The following table details key characteristics to consider when analyzing the four periods in focus:
Since the end of the last rising rate period, the level of rapid monetary and fiscal stimulus implemented (in response to the pandemic) has been unprecedented, likely leading to a faster recovery of the economy to full employment and much higher, and more persistent, inflation than originally anticipated.
Although history provides no clear example of how such extraordinary stimulus might be unwound, the Fed has indicated that rate hikes and tighter monetary policy will be needed to control inflation. Expectations are for the Fed to start this process with hikes starting in March 2022, followed by several more increases during the calendar year and beyond, with the speed and size dependent on the strength and evolution of the economic data over time.
Past performance of various fixed income strategies
Now that we’ve defined the past four rising rate periods, we can make several observations on how various fixed income strategies performed during those times.
Exhibit 2: Total Cumulative Returns of Select Indexes Over Recent Rising Rate Periods
- Shorter-duration strategies typically outperformed
Shorter-duration strategies have generally outperformed longer duration strategies during periods of rising rates, especially when rates rose rapidly. As seen in Exhibit 2, in periods 1 through 3, the BAML 3mo U.S. T-Bill (the 3Mo Bill), reflective of money market fund and ultra-short strategies with a duration of about 0.2 years, outperformed indexes reflective of core bond strategies, such as the U.S. Agg and the BAML U.S. C&G (both with durations of approximately seven years). It also outperformed indexes reflective of “short duration” mandates, such as the BAML 1-3yr U.S. C&G and the BAML 1-3yr Corp (each with a duration of approximately two years), as well as longer government-only indexes, such as the BAML 9-12-month UST.
- Pace and length of rate increases affect performance
During periods in which interest rates increased sharply and quickly, longer-duration indexes underperformed more dramatically. The steeper interest-rate-driven declines in market prices were unable to be offset by higher yields quickly enough. When rates rose in a more measured fashion, however, longer-duration indexes were able to reduce the magnitude of their underperformance, as seen in period 3, and even led to their outperformance, as seen in period 4.
It is worth mentioning that period 4 was an anomaly, as the Federal Open Market Committee hiked just once in both 2015 and 2016 before picking up the pace in 2017 (three hikes) and 2018 (four hikes), taking three years to raise the target fed funds rate from 0.25% to 2.50%. With just one hike in the first two years and a slow pace in 2017, the higher income of longer-duration strategies was able to more than offset price declines leading to outperformance over those years. However, as the Fed began to hike at a more normalized pace in 2018, as would be expected, shorter-duration indexes once again outperformed those with longer durations.
- Higher-yielding strategies outperformed
Higher-yielding indexes fared better than lower-yielding indexes with comparable maturities. Thus, the BAML 1-3yr Corp outperformed the lower-yielding BAML 1-3yr U.S. C&G (which has about 80% in government-related securities) for each period. This is primarily due to the yield cushion provided by corporate credit spreads, which helps to offset price declines. It also reflects the fact that rising rates typically accompany periods of economic expansion, which tend to support risk assets, sometimes leading to credit spread tightening.
- Shorter-duration strategies experienced less volatility
While strategies may exhibit similar overall returns during certain rising rate periods, the volatility they experience can vary greatly. Period 3 provides a good example. Here, the U.S. Agg and the BAML 1-3yr U.S. C&G both generated positive total returns of similar magnitude, yet the BAML 1-3yr U.S. C&G had roughly one-third the volatility of the longer-duration U.S. Agg. Meanwhile, 3Mo Bills not only delivered higher returns for the majority of the periods analyzed but also lower volatility than all of the other indexes illustrated, in all four periods.
KEY RISKS TO CONSIDER IN A RISING RATE PERIOD
Duration: an estimate of the sensitivity of a bond’s price to a change in interest rates
Spread duration: an estimate of the sensitivity of a credit-risky bond’s price to a change in the spread incorporated into that bond’s yield
Opportunity cost: the loss of potential gains from other investments, when a given investment is chosen
Extension risk: exists in securities that allow the borrower the option to pay down principal (prepay) earlier than originally scheduled, such as mortgage-backed securities. When rates rise, prepayments typically slow (as underlying borrowers are less likely to refinance), thereby extending the duration of a mortgage-backed security
Strategies for insulating a fixed income portfolio in a rising rate environment
Though some investors may choose to simply exit the asset class when rates rise, there are strong arguments for maintaining a core allocation to fixed income. In most interest rate environments, fixed income provides diversification, a steady stream of income and a lower volatility investment over time. Additionally, fixed income portfolios with longer durations have provided higher returns, albeit with greater volatility, over longer time horizons.
There are a number of strategies for investors with shorter investment horizons (especially those with potential near-term cash needs) or those seeking to preserve profits realized from longer-duration strategies, mitigating potential volatility and lower returns during the anticipated rising rate environment:
Selling longer-dated fixed coupon securities and/or reinvesting interest income and cash from matured securities into those with shorter tenors. These can run the gamut of money market instruments or ultra-short securities (typically utilized by institutional investors to lower duration) to stable net asset value money market funds (typically utilized by investors seeking capital preservation and liquidity) and ultra-short mutual funds or ETFs.
Purchasing floating rate notes, whose coupons reset on a regular basis. As a floater’s coupon resets to adjust for market changes, leading to lower duration, its price should typically experience less volatility.
Investing in higher coupon or higher-yielding securities, which have shorter interest rate durations relative to lower-yielding bonds with the same maturity. In addition to lowering duration, this strategy has the added benefit of providing greater income return, helping to offset declines in prices. However, higher yields due to increased credit exposure come with added risk. If credit spreads widen as rates rise, these securities could underperform.
Conclusion: Historical knowledge, dynamic insight
Unprecedented actions by the Fed over the last few years have left interest rates well below historical averages. As key economic metrics (such as employment) improve and even run hot (for example, inflation), indications are that the Fed will likely begin hiking rates soon and at a swift pace.
While history may provide clues, it is impossible to predict with certainty what the unwinding of such extraordinary monetary stimulus may look like. The only certainty is that when rates do rise, market values of portfolios of existing fixed coupon bonds will be negatively affected.
As this paper has demonstrated, using historical analysis, investors who seek liquid portfolios with limited exposure to the negative impacts of rising rates should find an effective solution in shorter-duration, higher-income strategies.