It’s been a difficult year for investors. We’ve witnessed above-average volatility across most asset classes, and fixed income has been no exception. Although the Federal Reserve’s aggressive rates hikes this year have created headwinds for financial markets, we think there’s a potential silver lining to the current environment. The increase in interest rates has opened the door for bond portfolios to capture higher yields. For those investors seeking income for retirement or other purposes, this might be what they’ve been waiting for all along. 

Although the default narrative has been that rising rates are bad for bonds, we think that’s a tad simplistic. Yes, higher rates can negatively impact the prices of most bonds in the near term, particularly in the early days of a new rate-hike cycle. But our view is that the total return potential of a duration-neutral bond portfolio (i.e., one that maintains the same interest rate risk as its benchmark) is closely correlated with yield over longer periods. Therefore, the increase in interest rates could actually improve the total return prospects for a bond portfolio going forward.

Of course, this isn’t just a random opinion. We’ve studied the performance of the Bloomberg US Aggregate Bond Index—a popular fixed income index and a proxy for a diversified bond portfolio—during the last five rising-rate cycles. These periods appear as the shaded areas in the graph below.

In each of the last five rising-rate cycles, the Bloomberg US Aggregate Bond Index delivered positive returns. Yes, there were instances of elevated volatility, typically seen leading up to and during the initial weeks of the new interest rate cycle as financial markets tried to gauge how far and for how long the Fed might hike. However, total returns for this diversified bond index ended positive in each of the last five rising rate cycles (defined as the time period from the first rate-hike to the first rate cut). 

For us, this offers compelling long-term evidence to stay the course with bonds. Some pundits have been suggesting that “this time is different” given he aggressive nature of the Fed’s recent moves and the fact that inflation is materially above the Fed’s target. However, it’s equally important to note that the inflation rate in the U.S. slowed more than expected to an annual rate of 8.5% in July of 2022 from a multi-decade high of 9.1% in the previous month, according to the U.S. Bureau of Labor Statistics. Not only might we already be seeing encouraging signs of moderating inflation, but there’s also the strong likelihood that the Fed may have front-loaded its monetary policy pivot (as seen with two 75 basis-point hikes already this year). 

So, the question for fixed income investors is what to do now? Our message has been consistent throughout these turbulent times. Bonds remain a critical component of a diversified portfolio.  Investors allocating to bonds should continue to invest in them for their income potential, as opposed to making bets based on interest rate predictions. And right now, the income potential of many bonds looks much improved versus recent years.

Remember, a rise in rates (and the corresponding lower principal prices) is only one part of the fixed income performance story. The long-term income generated by bonds is arguably the more important feature. We continue to champion the notion that income drives long-term fixed income returns, and any increase in rates can be offset by a higher income stream over time. Investors in bond funds should also remember that, generally speaking, bonds tend to mature at par. That means the downside volatility in bond pricing is often just a book loss (an accounting loss recorded along the way), but ultimately not one that will be realized by the investor.

All this suggests that while bond price volatility has been frustrating this year, investors should not forget the silver lining and income potential of that comes with the current environment.