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The Canadian Financial Advisor

If interest rates have nowhere to go but up, do bonds still have a positive expected return?

Benjamin Felix

In answering this question, the first thing to note is that interest rates could remain where they are currently, or go lower. There are already instances of negative bond yields across the globe. However, for discussion, we will assume that interest rates have nowhere to go but up.

The factors that matter most are the magnitude and time span of the interest rate increase, and the average duration of the bond portfolio. If interest rates were to increase by 0.5%, the effect on bond prices would be minimal. If interest rates increased by 10%, bond prices would be impacted significantly. If interest rates climb to a peak over the course of one month, the impact on bond prices will be more pronounced than if it occurs over a number of years. Large, short term increases in interest rates will likely result in negative performance for fixed income holdings. These negative effects become more pronounced as the duration of the bond portfolio increases.

Price risk is top of mind in a low interest rate environment. If interest rates can only go up, it seems like fixed income returns have nowhere to go but down. However, as interest rates go up, new bonds are issued at the new higher rates. As a bond portfolio receives coupon payments from the bonds that it owns, these coupon payments are reinvested in new bonds, at higher rates. Bond prices may decline with rising interest rates, but over time it is expected that purchasing new bonds with higher coupons will result in positive performance. Expected returns are independent of future interest rate scenarios, but realizing an expected return may come with periods of bond price volatility. As interest rates rise, a bond portfolio may exhibit negative performance over the short term, however, as coupon payments and principal repayments are reinvested at the new higher rates, the bond portfolio will be positioned for recovery.

If an investor is concerned about large negative returns in their fixed income portfolio, it is advisable to tend toward shorter-maturity bonds. Diversification can also help, reducing the bond portfolio’s dependence on any single country’s interest rate environment. In a rising rate environment, a globally diversified short-maturity bond portfolio is positioned to benefit.