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.

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).

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.

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.