Will Fed Rate Hikes Hurt Short-Term Bonds? | Lord Abbett
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Market View

History suggests otherwise, as short-term bonds have posted positive performance during years when the U.S. Federal Reserve has raised rates.

Read time: 4 minutes

The U.S. Federal Reserve (Fed) has provided increasing clarity regarding its plans to unwind the extreme monetary measures enacted at the start of the COVID-19 pandemic. As the market has adjusted to a quantitative easing (QE) tapering timeline that is expected to finish by Summer 2022, the focus for many market participants has shifted to the next stage of stimulus withdrawal—when the Fed will begin hiking interest rates. Driven in part by a strong economic recovery and inflation data that has stayed persistently higher than the expectations of many economists, markets have now priced in three, 25-basis point Fed hikes by the end of 2023.

While there are many market and economic implications for a series of hikes in the fed funds rate, one of the most direct is that short-term interest rates, such as those of short maturity Treasuries, will also typically rise. Many investors believe such a turn of events will inexorably lead to lower bond prices.

However, a rise in short-term rates does not necessarily mean that investors will lose money; indeed, experience with rate-hiking cycles demonstrates that this is rarely the case. To understand why—and dispel the notion that investors should fear Fed hikes—we can consider both the impact of market expectations and the actual experience of prior Fed hiking regimes.

Markets are extremely efficient when it comes to pricing in known information, particularly markets as large and liquid as the U.S. interest-rates market. The instant that expectations for the fed funds rate change, so does the yield for two-year U.S. Treasury securities, simply because the two-year Treasury yield at any point in time reflects expectations for the fed funds rate for the following two years. When the Fed hikes (or cuts) as expected, nothing really changes except the actual fed funds target rate; indeed, a cursory examination of prior Fed meetings with expected rate changes easily illustrates this point. All too often, two-year Treasuries don’t move at all when policymakers change the fed funds target, unless the Fed also introduces some new guidance about what might happen in the future.

The Bond Math

Yet even knowing that yields today already reflect future Fed hikes, some investors still may be uncomfortable investing in a security when they believe the yield will be higher in the future.  Investors may feel it is unwise to invest in, for example, a two-year Treasury when they believe the yield on two-year Treasuries will be higher in the future. Therefore, it is important to remember that bonds are securities with specific maturity dates. We cannot simply compare a two-year Treasury today with a two-year Treasury a year from now; they are different bonds. If an investor buys a two-year Treasury today, then a year from now, they will own a one-year Treasury, and will also have received a year of income.

The fact that a two-year Treasury at the same time in the future might have a higher yield will have no bearing on the initial investment. And an investor who chooses to sit on the sidelines for that year, to wait until yields are higher before they invest, will forego that year of income.

Yet while the theory is clear enough about why rising rates need not result in losses, it is also helpful that we have a substantial amount of data showing how investments have performed during Fed hiking cycles. The past two decades have provided us with two distinct periods to examine: between mid-2004 and mid-2006, the Fed implemented quarter-point rate hikes at 17 consecutive policy meetings, taking the fed funds rate up from 1% to 5.25% during a period of steady economic recovery. And during the 2015-2018 period, the Fed hiked nine more times after a prolonged interval of zero interest rates. And yet, two-year Treasuries generated positive returns for each year of rate hikes. Other short-dated asset classes, such as 1–3-year corporate bonds, were similarly positive. (See Figure 1.)

 

Figure 1. Short-Term Bonds Posted Positive Performance During Years of Fed Rate Hikes

Source: Bloomberg and U.S. Federal Reserve. Data compiled October 19, 2021. Returns for the two-year U.S. Treasury securities are based on the ICE BofA Current 2-Year U.S. Treasury Index; 1-3 year corporate bonds are represented by the ICE BofA 1-3 Year U.S. Corporate Bond Index.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment. 

 

Two-year Treasury yields rose in each year during those Fed hiking cycles, but these securities still generated positive returns, as that rise occurred largely in line with market expectations.  And, as discussed earlier, a two-year Treasury note at the start of each year had become a one-year Treasury by the end. With one exception, they did not experience the full rise of rates (based on the change in fed funds), and the income earned more than offset any price decrease that may have occurred.

As we are all aware, the past never repeats itself exactly. Investors can and do lose money as markets move, and there is no guarantee that prior experiences of positive returns will mean positive returns in the future. But given that the market already anticipates several rate hikes in the coming years, we can fairly assess that investments in short-term bonds need not be negatively impacted by Fed hikes when the Fed acts as the market anticipates.

Of course, this scenario would be upended should the Fed end up hiking at a more aggressive pace than the market expects. For example, if the Fed implements seven rate hikes by the end of 2023 instead of the three that the market has priced in, then it is reasonable to expect that, for the first time in many decades, short-term bonds could have negative returns during a Fed hiking cycle. But given the historical pace of Fed rate moves, such an outcome would be highly unlikely, in our view, and such an extreme pace of rate hikes would also likely impact other asset classes adversely.

Given the market’s well-grounded expectations for the Fed’s current policy path, short-term bonds may end up as one of the least volatile and better-performing asset classes as future rate hikes unfold.

 

Unless otherwise noted, all discussions are based on U.S. markets and U.S. monetary and fiscal policies.

Asset allocation or diversification does not guarantee a profit or protect against loss in declining markets.

No investing strategy can overcome all market volatility or guarantee future results.

The value of investments and any income from them is not guaranteed and may fall as well as rise, and an investor may not get back the amount originally invested. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.

Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

Fixed-Income Investing Risks

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. 

The credit quality of fixed-income securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

This material may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The views and opinions expressed are as of the date of publication, and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions and Lord Abbett disclaims any responsibility to update such views. Lord Abbett cannot be responsible for any direct or incidental loss incurred by applying any of the information offered.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

Please consult your investment professional for additional information concerning your specific situation.

Glossary & Index Definitions

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

basis point is one one-hundredth of a percentage point.

The federal funds (fed funds) rate is the target interest rate set by the Fed at which commercial banks borrow and lend their excess reserves to each other overnight.

 

Yield is the income returned on an investment, such as the interest received from holding a security. The yield is usually expressed as an annual percentage rate based on the investment's cost, current market value, or face value.

The ICE BofA 1-3 Year U.S. Corporate Index is an unmanaged index comprised of U.S. dollar-denominated, investment- grade, corporate debt securities publicly issued in the U.S. domestic market with between one and three years remaining to final maturity.

The ICE BofAML Current 2-Year U.S. Treasury Index is a one-security index comprised of the most recently issued two-year U.S. Treasury note. The index is rebalanced monthly.

Source ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofAML INDICES AND RELATED DATA ON AN “AS IS” BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofAML INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD ABBETT, OR ANY OF ITS PRODUCTS OR SERVICES.

The Bloomberg U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade, fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.

Bloomberg Index Information


Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg owns all proprietary rights in the Bloomberg Indices. Bloomberg does not approve or endorse this material or guarantee the accuracy or completeness of any information herein, or make any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, shall not have any liability or responsibility for injury or damages arising in connection therewith.

This material is the copyright © 2021 of Lord, Abbett & Co. LLC. All Rights Reserved.

 

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