Given last week’s announcement from the Federal Reserve, it is clear that the U.S. is moving toward a period of rising interest rates. As a result, many investors are likely wondering: what does Fed policy mean for a fixed income portfolio?

An analysis of the performance of different fixed income strategies during past rising rate cycles can provide valuable perspective for a fixed income investor managing through a rising rate environment. To do this, we have identified four past rising rate cycles in recent history.

The first three periods can be considered more “traditional”: the 10-year U.S. Treasury rose significantly alongside relatively swift, successive rate hikes from the FOMC. During 1994–95 (period one), the Fed hiked the target rate seven times over 12 months, from 3.00% to 6.00%; during the second period, 1998-2000, the Fed hiked the target rate six times over 11 months, from 4.75% to 6.50%; and in the third period, 2003–2006, the Fed raised the target rate 17 times over 24 months from 1.00% to 5.25%, a more measured pace but still a large shift. 

The fourth period from 2015 to 2018, however, was an anomaly: the FOMC 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%.    

The pace and length of time over which rate increases take place affect performance, as we show in the chart below. During periods in which interest rates increased sharply and quickly, longer duration indexes underperformed, at times dramatically. However, when rates rose over a longer period of time and in a more measured fashion, as they did partially in period three and particularly in period four, negative price returns were offset by the greater interest income earned over a longer period of time. This reduced the magnitude of underperformance of some longer strategies in period three and lead to their outperformance in period four.

Additionally, across time periods, higher-yielding indexes fared better than lower-yielding indexes with comparable maturities, and performance volatility was lower for the shortest duration strategies. 

Looking forward, while we don’t yet know which of the previous periods the next cycle will best resemble, the market is currently pricing Fed “liftoff” in mid-2022, with a total of five hikes complete by the end of 2023. This suggests that the impending hiking cycle will lean in the direction of periods one and two in our analysis.      

As we’ve seen in the past, during periods of quickly rising interest rates and stable credit conditions, investors can improve the total return of their bond portfolios by shifting into shorter duration and higher-income-generating strategies.