Rising rates: Short-term pain for long-term gain?

Investors have likely noticed the improved opportunity set in fixed income due to higher yields. 

And yet some investors may be hesitant to take advantage of higher yields because of concerns about future increases in yields. 

Some may even be considering reducing their bond exposure after this year’s negative returns for fixed income. (The Bloomberg Global Aggregate Bond Index (hedged to SGD) returned -12.2% from 1 Jan 2022 through 30 Sept 2022.)

The good news? If yields do keep rising, investors seeking higher expected returns may still be better off maintaining the duration of their fixed-income allocation. 

Rising yields impact fixed-income portfolios in several ways. On the one hand, longer-duration portfolios may experience larger immediate losses from increased yields relative to shorter-duration portfolios. On the other hand, higher yields may lead to higher expected returns.

Investors can think of this tradeoff as a pit stop in a Formula 1 race. The pit stop immediately causes the driver to fall back. However, fresh tires may help the driver win the race if there are enough laps left to catch the leader. 

The following chart illustrates this using two scenarios for a S$100,000 fixed-income allocation with a five-year duration. 

• Scenario 1 experiences a constant yield of 1% during the period. 
• Scenario 2 is faced with a sudden spike in yield from 1% to 4% on Day 1, and sees its value immediately drop to a little over S$86,000. 

However, the higher-yield environment accelerates Scenario 2's recovery: With a 4% yield rather than the previous rate of 1%, Scenario 2’s portfolio value overtakes Scenario 1's within five years — the time horizon determined by the duration of Scenario 2. 

When faced with uncertainty, investors should focus on the things they can control. 

Research tells us that trying to outguess the market by holding on to cash, or shortening duration, with the expectation of future yield increases may not help you achieve your long-term goals.

Markets quickly incorporate new information about higher interest rates and inflation. 

Investors who maintain appropriate asset allocations, even after increases in bond yields, may have a more rewarding investment experience in the long run.

This article was originally published by Dimensional Fund Advisors on 10 Oct 2022.

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Glossary

• Duration: A measurement of the sensitivity of the price of a fixed-income investment to changes in interest rates. Generally, high-duration bonds will have greater sensitivity to changing interest rates than lower-duration bonds.
• Interest rates: In the bond market, the interest rate determines the amount of money that an issuer pays bondholders. Interest rates tend to fall when the economy contracts and rises when the economy expands.

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