Fixed Income Returns During Rising Rates

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Craig Israelsen, Ph.D., creator of the 7Twelve portfolio, consultant to 7Twelve Advisors, LLC and executive-in-residence in the Financial Planning Program at Utah Valley University. 

I am certainly not in the business of predicting interest rate movement. If rates increase—don’t know when or by how much—what type of performance might we expect from fixed income? Our only guide, albeit fuzzy, is what’s happened in the past.

Let’s examine several periods of rising rates (using the Federal Discount rate) over the past nearly 45 years (January 1976 – October 2020). The first period of rising rates was January 1976 to December 1981. The second period was January 2002 to December 2007. The third was from January 2016 to December 2018.

Three Periods of Rising Rates:

6-year period from January 1976 – December 1981
6-year period from January 2002 – December 2007
3-year period from January 2016 – December 2018

1976-1981: Rising Rates

The six-year period from January 1976 to December 1981 saw an increase in the Federal Discount rate from 5.79% to 12.10%—and rising rates generally represent a head wind for fixed income. As might be expected, the long bond index was hit hardest, and experienced a six-year annualized return of 2.47%, which was substantially below its 8.88% annualized return over the past nearly 45 years (1976 through Oct. 31, 2020).

The short and intermediate bond indexes posted reasonably impressive gains of 7.31% and 6.34%, respectively. The aggregate bond index had a 5.04% annualized return. The 45-year annualized return for the 1- to 5-year index has been 6.36%, while the annualized return for the same period was 7.49% for the intermediate index and 7.28% for the aggregate bond index. Understandably, since 1981, we have generally been in a period of declining rates, hence the impressive 45-year returns for these four bond indexes.

For those who do not remember the late 1970s, we are the aged messengers to remind you that inflation (as measured by the CPI) grew at an annualized rate of 9.18% from 1976-1981—essentially eclipsing the performance of all the fixed income indexes. Thus, all four fixed income indexes had a negative real rate of return between 1976-1981.

For comparison, during this same six-year period, the equally weighted S&P 500 Index had a banner run—producing an annualized return of 16.73%. The MSCI EAFE Index was next, at 12.38%, followed by the market-cap-weighted S&P 500 Index, at 10.62%. Finally, commodities (as measured by the S&P Goldman Sachs Commodity Index) had a six-year annualized return of 6.56%. All but commodities turned in a positive real rate of return during this period of rising rates from 1976-1981.

2002-2007: Rising Rates Again

The second period that we will examine in which interest rates rose was the six-year period from January 2002 to December 2007. The Federal Discount rate moved from 1.25% to 4.75%. During that same time, short-term bonds cranked out a return of 4.34%, intermediate bonds returned just over 5.4%, and the aggregate bond index had a 5.37% annualized return.

The surprise was the long-bond index that generated a six-year annualized return of 7.03% during that particular period of rising rates. Inflation over the same time frame grew at 2.92%—resulting in a positive real rate of return for each of the fixed income indexes being examined.

On the equity and diversifier side, commodities stood out as the real winner from 2002-2007, turning in an annualized return of 17.60%. After netting out inflation, the real rate of return was over 14%.

The performance gap between the equal-weighted S&P 500 Index (9.39%) and the cap-weighted S&P 500 Index (6.07%) is interesting to note. Non-U.S. equities produced an annualized return of 14.34%—more than double the return of U.S. large cap stock (at least, the market capitalization weighted version).

2016-2018: Upward Blip

During the three-year period from January 2016 – December 2018, the Federal Discount rate went from 1.00% to 3.00%. The four bond indexes posted positive three-year annualized returns—with the long credit index doing the best.

What if we use a different measure of interest rate movement?

Shown below is the path of the 10-year Treasury rate since 1976. I’ve highlighted two periods in which rates rose: one period experienced a significant rise (1976-1981), and the other a minor upward blip (2016-2018). Same story: the 10-year Treasury rose, and these four bond indexes produced positive annualized returns.

Two Periods of Rising Rates:

6-Year period from January 1976 – December 1981
3-year period from January 2016 – December 2018

So, Now What?

Based on the reasonably acceptable performance of these four bond indexes during these past periods in which interest rates moved upward, it would seem unwise to “un-balance” a portfolio by entirely dumping fixed income—even when it appears that interest rates have nowhere to go but up.

I readily acknowledge that bond performance can struggle during periods of rising rates. The bigger question is, How bad is the struggle.

As this article has attempted to demonstrate, there was clearly not a performance meltdown among these key bond indexes during the rising rate periods that have been highlighted.

All that said, there are at least three prudent approaches toward fixed income as we head into 2021 and beyond.

1. Shorten the duration of the bonds and/or bond funds being used in a diversified portfolio.

2) Use actively managed bond funds or ETFs in your portfolio.

3) Include non-U.S. bond funds/ETFs in your portfolio.

There’s no guarantee investing in these funds will be the perfect remedy, but based on historical data, they look to be good prospects when the fixed income scenario changes. 

Contact Craig Israelsen at [email protected]