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Rising Rates: Short-Term Pain for Long-Term Gain? Thumbnail

Rising Rates: Short-Term Pain for Long-Term Gain?

In the News Investing

Dimensional Fund Advisors

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.1 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.

Exhibit 1 illustrates this using two scenarios for a $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 $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. 

Graph comparing long-term performance of a hypothetical fixed income portfolio in a steady interest rate environment vs. one in a steeply rising interest rate environment.

                                                          Source: Dimensional Fund Advisors

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.2 Markets quickly incorporate new information about higher interest rates and inflation.3 Investors who maintain appropriate asset allocations, even after increases in bond yields, may have a more rewarding investment experience in the long run.

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.

  1. The Bloomberg Global Aggregate Bond Index (hedged to USD) returned –12.1% from January 1, 2022, through September 30, 2022. The Bloomberg U.S. Aggregate Bond Index is a broad-based fixed income index including government Treasury securities, corporate bonds, mortgage-backed securities, asset-backed securities, and municipal bonds to simulate the universe of bonds in the market. 
  2. Doug Longo, “Bonds Deliver Positive Returns in July 2022,” Insights (blog), Dimensional Fund Advisors, August 12, 2022.
  3. Wes Crill, “Light at the End of the Inflation Tunnel,” Insights (blog), Dimensional Fund Advisors, June 10, 2022;  “Markets Appeared to Be Ahead of the Fed,” Insights (blog), Dimensional, June 16, 2022.

The index performance data appearing or referenced (directly or indirectly) herein has been compiled by the respective copyright holders, trademark holders, or publication/distribution right owners of each index. Historical performance results for investment indexes and/or categories are for illustrative purposes only and do not represent actual portfolio performance. The indexes and/or categories generally do not reflect the deduction of transaction and/or custodial charges, or the deduction of an investment-management fee, which would decrease historical performance results. Investors cannot invest directly in an index. 

This content is developed from sources believed to be providing accurate information as of the date of publication, and is intended for informational purposes only. Please consult your financial professionals for specific information regarding your individual situation. Past performance does not guarantee future results. All investing involves risk, including risk of loss.