If you Google “higher for longer,” you’ll get the impression that higher interest rates that stick around for a while are a bad thing. Many articles state that corporations won’t be able to withstand the higher costs associated with higher rates. Other articles say that a federal funds rate² that stays at 5% or higher portends trouble for the equity markets and equity funds. Perhaps these prognostications will prove to be accurate, but what could higher for longer mean for bonds and bond funds? 

I think higher for longer could be advantageous for bond-fund investors, especially for those who invest in higher-quality bonds. I see three main advantages of higher-for-longer rates:

While today's issuance generally starts off at par, there's a whole cohort of bonds issued before 2022 that now trade at a discount.

^{However, as interest rates rose from historic lows in 2021, and as the Federal Reserve (Fed) took its target rate from 0% in March 2022 to the 5.50% upper bound as of January 2024, IG corporate coupons in 2022 and 2023 began to rise and approach their pre-GFC levels (FIGURE 1). The combined average for both 2022 and 2023 IG corporate debt was a just basis point under 5% for more than 2,500 different fixed-rate securities. Issuance in 2024 has yet to show any signs of slowing down: January set a record with $188 billion of issuance, with the fixed-rate portion averaging 5.31%. This issuance is feeding bond funds as money moves back to taxable bonds ($221 billion in 2023 per Morningstar) and as mutual-fund dividends get reinvested.} 

Capital Appreciation Opportunities

2022 was a year of reckoning for fixed income with the Bloomberg US Aggregate Bond Index (the “Agg”)⁶ losing more than 13%. High-quality bonds, which for years had been at par or better, saw the most significant price declines since the mid-1980s. However, most of these losses can be traced back to the steep back-up in interest rates and weren’t tied to credit or default issues.

While today’s issuance at higher rates generally starts off at par, there’s a whole cohort of bonds issued before 2022 that now trade at a discount. The Bloomberg US Corporate Index⁷ shows more than 5,300 bonds issued between 2010 and 2021 trading at an average price of 89 cents on the dollar as of 1/31/24. The average coupon of those securities is only 3.58%, but the discount on the bonds has the potential to increase total return as the bonds move closer to par.

Yield-to-worst⁸ is a measure that combines both current coupon levels and price appreciation to reflect total-return potential in a given year. As of 1/31/24, the measure was 5.11% for the Bloomberg US Corporate Index vs. 2.33% at the end of 2021.

As rates remain higher for longer, the natural progression would be for new bonds to roll on at higher rates and old bonds to accrete⁹ back to par. A meaningful back-up in rates from here would delay this accretion. A significant decline would accelerate the accretion but also potentially lower the coupons of the new issuance moving forward. Ideally, an extended time period in which rates remain higher for longer could reset a significant amount of bonds in funds and ETFs where coupon would be the main driver of return rather than appreciation. That scenario brings bond funds back to the role they’re meant to play: to seek to provide consistent income and a potential offset to equity risk.

Higher Rates—Bigger Potential Buffer

It’s also important to remember that, within a bond fund, bonds with higher rates have less interest-rate risk. In general, the higher a fund’s duration,¹⁰ the more sensitive it is to up-or-down interest-rate moves. Duration is directly impacted by the level of coupons in the fund, among other things. The higher a bond’s coupon, the shorter its duration, because the investor receives more of its total return in the form of interest payments before final maturity. The opposite is true with lower coupons as the investor is getting less in the form of interest payments. The impact of higher coupons in a bond fund may help provide some ballast in volatile rate markets—all else being equal (FIGURE 2).

There comes a point at which high rates create more credit risk. However, bonds with higher coupons provide an added benefit of potentially reducing interest-rate volatility.

There’s a balance to be struck because, potentially, there comes a point at which high rates create more credit risk. However, bonds with higher coupons provide an added benefit of potentially reducing interest-rate volatility.

How Long Is Too Long?

This is the question much of the market is grappling with. The fear is that rates at these levels will slow economic growth. But slower growth doesn’t mean no growth. The US 10-year Treasury rate was approximately 4.24% as of 2/29/24. Prior to 2008, going back to 1980, borrowing at levels above 4% was the rule, not the exception. During this period, GDP grew at an average rate of 3.01% per year with only three negative years (FIGURE 3). In addition, the S&P 500 Index¹¹ returned 14% per year on average from 1980 to the end of 2007. Many other factors outside of rates (technology, innovation, productivity, etc.) can impact growth. It’s been shown that rates at these levels don’t have to bring growth to a screeching halt, and the economy has historically figured out a way to function regardless of where the 10-year note trades. 

Conclusion

The term higher-for-longer has often taken on a negative connotation. However, it actually appears rates are returning back to pre-GFC norms. The goal of many  bond funds has been to earn income while preserving capital and helping to reduce drawdowns within a portfolio. However, at a low level of interest rates, bonds funds haven’t been providing enough income for some and have lost some of that ability to offset equity losses.

These days, more high-quality debt is being issued at levels above 5%. In addition, the rate back-up from 2022 pushed many bonds into a discount despite the likelihood of defaults being remote. That’s created capital-appreciation opportunities on top of more income being added via new issuance. These higher levels can provide more stability in a volatile rate environment without necessarily damaging the whole economy.

Talk to your financial professional to help you construct a bond portfolio that's right for you.

^{Past performance does not guarantee future results. Investors cannot directly invest in indices.}

¹ The term “at par” means at face value. A bond, preferred stock, or other debt instrument may trade at par, below par, or above par. Par value is static, unlike market value, which fluctuates with credit ratings, time to maturity, and interest rate fluctuations.

² The federal funds rate is the target interest rate set by the Federal Open Market Committee. This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.

³ De minimis is Latin for “about minimal things.”

⁴ Investment-grade (IG) bonds are believed to have a lower risk of default and receive higher ratings by the credit rating agencies, namely bonds rated Baa (by Moody’s) or BBB (by S&P and Fitch) or above. These bonds tend to be issued at lower yields than less creditworthy bonds.

⁵ A basis point (bps) is a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indices and the yield of a fixed-income security.

⁶ Bloomberg US Aggregate Bond Index is composed of securities that cover the US investment-grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

⁷ The Bloomberg US Corporate Index measures the investment grade, fixed-rate, taxable corporate bond market.

⁸ Yield-to-worst is a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting.

⁹ In finance, accretion refers to the accumulation of the additional income an investor expects to receive after purchasing a bond at a discount and holding it until maturity. Par is the face value of a bond, which defines its maturity value and the dollar value of coupon payments.

¹⁰ Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.

¹¹ S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks.

Important Risks: Investing involves risk, including the possible loss of principal. • Fixed-income security risks include credit, liquidity, call, duration, event and interest-rate risk. As interest rates rise, bond prices generally fall. • U.S. Treasury securities are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest.

The views expressed here are those of the author. They should not be construed as investment advice. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Hartford Funds.