Demystifying Three Bond Myths During Rising Rates
With multiple interest rate hikes on the horizon, some bond investors may be feeling concerned. This infographic debunks three common myths about bonds during rising rate environments and explains why they may be beneficial.
Demystifying Three Bond Myths During Rising Rates
Today U.S. Treasury yields, a key return measure for bonds, are over 1% higher than pre-pandemic levels.
January 2020: 1.8%
May 2022: 2.9*
*As of May 17, 2022
While rising interest rates are often seen to have a negative impact on bonds, the current environment may be beneficial.
In this infographic from New York Life Investments, we debunk three common myths about bonds during rising rate environments to explain why.
Bonds During Rising Interest Rates
To start, here’s a brief introduction on how bond yields are affected by interest rates.
Bond yields are the return investors will earn from a bond over a period of time. Bond investors receive interest for purchasing debt issued by the government or a corporation. For instance, a $1,000 bond with a 3% yield would earn $30 annually.
Rising interest rates directly affect bonds.
When interest rates rise, bond yields typically rise. As investors seek out new bonds that provide higher yields (income), the demand for existing lower-yielding bonds declines. Consequently, the price of these existing bonds typically falls.
Given this backdrop, let’s explore how bonds have historically performed during rising rates, the potential buying opportunities they present, and their long-term performance in a rising rate climate.
Myth #1: “Never Hold Bonds During a Rising Rate Environment”
Answer: False
Even during multiple rising rate periods, bonds have shown positive performance in the last 38 out of 42 years. Let’s take a look at the two most recent rising rate periods:
As shown above, every type of bond showed positive performance.
High-yield bonds returned the highest over the last two rising rate periods, averaging 7.9%. Not only that, when equities decline, bonds have often cushioned losses, as seen in the Great Financial Crisis and the COVID-19 market crash.
Myth #2: “This Is the Worst Time to Invest In Bonds”
Answer: False
Rather than doom and gloom, the current environment could present a buying opportunity. Consider how municipal (muni) bonds have performed after historically low periods:
In the 12 months following each trough date, muni bonds rebounded notably.
For example, after falling over 11% during the Global Financial Crisis, munis returned nearly 20% in the 12 months after. Munis also could potentially benefit from other key factors including solid credit fundamentals and the $350 billion federal stimulus to state and local budgets.
Not only that as bond prices dip, a “buy low” opportunity may be present not only in munis, but other areas of the bond market.
Myth #3: “The Long-Term View Looks Dismal”
Answer: False
When taking a long-term perspective, investors could potentially generate more income from their bond holdings in a rising rate environment than they would have otherwise.
Here’s how investors can capitalize on rising rates as bonds mature, given the following assumptions:
Every year, a maturing bond is replaced with a new 5-year bond.
The yield is 20 basis points (bps) higher on each new bond.
Over the long term, a rising rate environment more than doubled the bond portfolio’s return compared to the falling rate scenario.
With this in mind, active management and a long-term strategy can potentially benefit investors during today’s rising interest rate environment.
Research shows that active approaches to fixed income have generally outperformed passive strategies by diversifying across the maturity spectrum while proactively balancing risk and return. Active strategies can seek out new opportunities as interest rates shift, addressing a broader scope of the bond market.
The Case for Bonds
With inflation and bond yields on the rise, purchasing newly-issued bonds at higher rates can help offset this impact. While bonds may not seem like the obvious choice for investors amid rising rates, history shows us that they may be worth a closer look.