A Look Back at History: Rising Rates and the Bond Market

Overall, fixed income delivered positive results during the past three Federal Reserve rate tightening cycles.

With the Federal Reserve (Fed) having increased its target rate in December 2015 and again in December 2016, investors are wondering how may hikes to expect in 2017. The Fed’s statement following its December 2016 FOMC meeting suggested three hikes could be in store for next year.

Of course, much will depend on how the economy actually performs. Consider that after increasing rates in December 2015, the Fed initially implied that four rate hikes were possible in 2016 -- a prediction that did not pan out.

Still, if we are actually on the cusp of an extended Fed tightening cycle, fixed-income investors are certainly interested in how it could impact their portfolios. A look back at history provides some perspective for investors that suggests there may be benefits to staying put and “riding out” the cycle, instead of rushing for the exits or pursuing a market-timing strategy.

Surprising performance

Indeed, an analysis of representative index performance provides interesting insight into what investors might expect when interest rates are rising.

In the three most recent Fed tightening cycles (1994–1995, 1999-2000, 2004–2006), a positive total return resulted as coupon interest payments more than offset price declines.1

More importantly, index performance was solid across the entire interest rate cycle (defined here as the 12 months preceding the onset of Fed tightening to 12 months after the last rate hike).

Performance was negative on just a few occasions during the most challenging part of the cycle: from the low in the benchmark 10-year Treasury yield to its high.

The active advantage

In our opinion, an actively managed bond approach offers the potential for a better return than passive index investing. So, while index performance was positive during recent Fed tightening cycles, professional management of diversified fixed income investments could offer several important potential advantages:

• A degree of diversification that most investors in individual bonds cannot attain on their own.
• The ability to play defense when interest rates are rising, by managing duration, something that a passive index cannot do.
• The expertise to take advantage of values created in all sectors of the market through effective security analysis and sector rotation, potentially enhancing total return.

Periods of rising interest rates are a normal part of bond investing, but that doesn’t mean that they don’t create anxiety. However, before making any impulsive moves out of fixed income, you should carefully consider the risks involved in attempting to time moves in and out of the market, including the potential for unwanted taxable events.

For more detail on how bond markets reacted during past tightening cycles and the potential benefits of “riding it out,” read the full report.