All It Takes Is Time: Higher Rates are Good for Short-Term Investor

February 25, 2022
Bond investors have experienced an historic rate shock over the last few months, while the Fed is likely to raise rates higher and sooner than expected. The good news is, if you maintain a constant maturity, your money is now reinvested at these higher rates. Combined with the likelihood that a bond's price approaches par as it nears maturity, the improved yield should more than make up the temporary loss in value over time.

Bond investors have experienced an historic rate shock over the last few months, as financial markets absorbed first the Federal Reserve’s (Fed) concession that inflation might be more stubborn than previously thought, and then the reality that the Fed is likely to raise rates higher and sooner than expected. It also provided a reminder to fixed income investors that bonds and notes are marked-to-market,1 and even a money market instrument or a Treasury Bill decreases in market value when rates rise. The good news is, if you maintain a constant maturity, your money is now reinvested at these higher rates. Combined with the likelihood that a bond’s price approaches par as it nears maturity, the improved yield should more than make up the temporary loss in value over time.

To illustrate the price vs. income effect over time, we can take one potential interest rate scenario (we present several in Exhibit I) and show the components of return for a one-year credit portfolio. The lighter bars show the price effect of the increase in rates from November to mid-February, then an additional 0.25% each quarter thereafter. The darker bars describe the portfolio’s income return earned over each quarter.

Exhibit 1 – Hypothetical Return Scenario, Actual Last 3 Months + Market-Implied Rate Increases. Stacked bar chart showing the quarterly income levels and the price effect from changes in yields for the representative short duration credit portfolio with a duration of 1.0 year. This chart includes a plotted point for each time period that shows the combined effect of positive returns from income and negative returns from assumed price declines. The graph includes five discrete three-month periods: the actual three months ending 2/10/22, and the hypothetical total return for the trailing three months ending 5/10/22, 8/10/22, 11/10/22, and 2/10/23. Total returns are positive and increasing for the forecasted periods due to increasing levels of income.

Future returns require an even larger interest rate move to produce a similarly negative return over three-month time periods. Back in November, bond markets had priced in an increase in the one-year Treasury rate of about 0.2%, expecting them to reach 0.45% in mid-February, and only 3-4 Fed hikes in 2022. Expectations have moved much faster than November’s expectation, with one-year Treasuries now hovering over 1% and investors expecting several additional rate hikes. To give a sense of how unusual this change in short-term rates was, 1-3 year Treasuries have almost never produced a negative 12-month return, and the few exceptions were tiny declines (2005 and 2018). This rate surprise since November produced an historic decline (see Exhibit II).

Exhibit 2 – U.S. Treasury Yield Curve. Line graphs with plots that show the yield to maturity of U.S. Treasury securities along the vertical axis and the tenor, or the time to maturity in years, along the horizontal axis. The exhibit shows the yield curves on November 10, 2021, the market-expected yield curve on February 10, 2022 on November 10, 2021 (i.e., the 3 month forward yield curve on November 10, 2021), the yield curve on February 10, 2022, and the market-expected yield curve on May 10, 2022 on February 10, 2022 (i.e., the 3 month forward yield curve on February 10, 2022). The exhibit is designed to illustrate that actual yields on 2/10/2022 were well above what the market expected three months ago.

A confluence of four factors makes this recent episode unique:

1.  The rapid rise in rates comes off a base of closer to 0%, so there was little income being earned to protect against price declines from higher rates,

2.  The slope of the yield curve at the front end was relatively flat three months ago, reflecting the fact that investors were not too concerned about near-term prospects of higher interest rates (see Exhibit III),

3.  Inflation now seems to be stickier, and harder to predict. This differs from the more-recent Fed rate hike cycle of 2016 – 2018, when rates rose, but inflation did not rise to levels of concern, and

4.  Investors have priced in a substantial number of additional Fed rate hikes (7 hikes of 25 bps2 over a 12-month period) to combat inflationary pressures.


Exhibit 3 – Rolling 1 Year Total Return – Bloomberg 1-3 Year Treasury Index. Bar chart showing the trailing one year total return of the Bloomberg 1-3 Year Treasury Index going back to December 1992. Three periods are annotated: March 2005, when the trailing one year total return was -0.41%, April 2018, when the trailing one year total return was -0.32%, and February 2022, when the trailing one year total return was -2.17%.

These factors combined to catch many investors and managers by surprise. 95% of the 206 funds within the Morningstar Ultrashort Bond mutual fund category had negative returns over the past three months ending 2/11/22, with the best-performing funds attaining paltry positive returns less than 0.1%. Funds in the category performed in a relatively narrow band.3

What makes this recent environment unique is that performance has been driven by changes in U.S. Treasury rates, the risk-free rate of return. Credit or liquidity conditions have had less impact on performance. Credit-driven declines may be more problematic, although episodes of credit-driven underperformance have tended to reverse quickly and with greater magnitudes of returns.

Our clients invested in short duration credit portfolios were not immune to this environment. We are never happy to produce a negative return. However, those portfolios are positioned to overcome those declines over time. Further, it is important for investors to remember that:

  • They have been insulated from much more negative returns through the portfolio’s short duration (duration is the return sensitivity of 1% for every 1% increase in rates) as opposed to the broader bond market, which is several times more sensitive to rate changes. The Bloomberg Aggregate Index of investment grade bonds is down 3.45% year-to-date.
  • For that reason, the higher yields in the strategy should turn returns positive sooner than for longer portfolios and should lead to higher returns in the future. With a shorter duration, the portfolio does not have to wait as long for the return of principal that can be reinvested at higher rates.

Return outlook in a rising-rate environment

We explored the “What? Why? And How?” of the recent rise in interest rates. Now we turn to illustrating why these higher rates are good for fixed income investors – even if rates continue to rise at the current market-implied pace.

Let us illustrate using the same short duration credit portfolio mentioned earlier. One of the frequent questions we get is “everyone knows the Fed will raise rates – will we continue to lose money?” The short answer is that we do not know, but the outlook looks more favorable to investors.

We examine four scenarios – all of which only assume that rates will continue to rise:

  • Scenario 1. “Fed Slower.” Rates rise, but at a slower pace than predicted by investors for the next 3 months. After that, rates rise at a pace of 0.25% per quarter.
  • Scenario 2. “Higher Rate Surprise.” The 1-year Treasury yield rises at a pace of 0.25% per quarter.
  • Scenario 3. “Forward Curve.” (this is the scenario depicted in the bar chart at the beginning of this note) The 1-year Treasury yield follows the path predicted by forward curve as of February 11, 2022.
  • Scenario 4. “Fast Surprise.” The 1-year Treasury yield rises to 2% then rises at a pace of 0.25% per quarter.

Exhibit IV illustrates that total returns – the combination of the higher levels of income earned and the forecasted price decline in a rising-rate environment – skew overwhelmingly positive in these rising rate scenarios. This is attributable to investors benefitting from the income earned as interest rates move higher.


Exhibit IV: Illustrative Short Duration Credit Portfolio Total Return Scenario Analysis

Scenario 1
Fed Slower

Scenario 2
Higher Rate Surprise

Scenario 3
Forward Curve

Scenario 4
Fast Surprise
3 months 0.32 0.21 0.01 -0.39
6 months 0.66 0.48 0.34 0.05
9 months 0.93 0.81 0.48 0.55
12 months 1.26 1.20 0.53 1.12
Changes in One Year Treasury Over
3 months 0.13 0.25 0.48 0.93
6 months 0.25 0.50 0.70 1.18
9 months 0.50 0.75 0.84 1.43
12 months 0.75 1.00 0.97 1.68
All scenarios assume a net-of-fee experience with credit spreads and portfolio duration held constant (duration of 1.0 year).
This hypothetical example illustrates the invserve relationship of rising interest rates, the value of fixed income investments and their duration.
Data as of February 10, 2022
Source: Bloomberg and BBH Analysis

One thing we can promise you: the future path of interest rates won’t look exactly like any of these illustrations. It will be bumpy, with overshoots and corrections related to the pace of Fed rate hikes. A short duration credit portfolio could be in positive territory in a week or two, or it could take months. But one thing is clear – these price declines are a direct function of higher rates, and investors benefit from higher rates pretty quickly when you have a short duration portfolio.

1Marked-to-Market refers to a method of measuring the fair value of securities or portfolios using prices observed in the market.
2One "basis point" or "bp" is 1/100th of a percent (0.01% or 0.0001).
3Bloomberg, through 2/10/2022.

Issuers with credit ratings of AA or better are considered to be of high credit quality, with little risk of issuer failure. Issuers with credit ratings of BBB or better are considered to be of good credit quality, with adequate capacity to meet financial commitments. Issuers with credit ratings below BBB are considered speculative in nature and are vulnerable to the possibility of issuer failure or business interruption.

Opinions, forecasts, and discussions about investment strategies represent the author's views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.


Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed.

Investors should be able to withstand short-term fluctuations in the fixed income markets in return for potentially higher returns over the long term. The value of portfolios changes every day and can be affected by changes in interest rates, general market conditions and other political, social and economic developments.

The Bloomberg U.S. 1-3 Year Treasury Bond Index is an unmanaged index of fixed rate obligations of the U.S. Treasury with maturities ranging from 1 to 3 years.

The indices are not available for direct investment. The Strategy’s holdings are materially different than the composition of the indices. The Strategy does not measure its performance success nor alter its construction in relation to any particular benchmark or index.

“Bloomberg®” and the Bloomberg indexes are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indexes (collectively, “Bloomberg”) and have been licensed for use for certain purposes by Brown Brothers Harriman & Co (BBH). Bloomberg is not affiliated with BBH, and Bloomberg does not approve, endorse, review, or recommend the BBH Strategy. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to the strategy.

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