As the world continues to adapt to a new normal, governments and consumers have been turbocharging the economy with a spending spree that’s been fueling economic growth while also reigniting inflation around the globe. No party is complete without a hangover or two, and that’s been especially true for fixed-income investors who’ve seen rising interest rates erode the value of their traditional bond allocations.

Holding a portion of your portfolio in high-quality assets with some duration has actually helped mitigate the pain of equity losses. 

Bond Funds Can Self-Heal Over Time 

This is not to say bonds and bond funds can’t lose money. They certainly can, although the losses tend to pale in comparison to equities. In fact, since 2001, quarterly losses for the Agg have historically foreshadowed a gain over the next 12 months (FIGURE 2).

While it’s true that bond values generally drop as interest rates rise, patient investors can potentially recover some percentage of that lost value if they’re willing to hold their investment beyond its normal duration. As each day goes by, and as a bond approaches its maturity, the value of that bond gets closer to par. That’s how a bond’s diminished value can eventually be recouped regardless of future rates—provided the borrower repays the principal.

This “self-healing” feature of bonds may be even more pronounced with bond funds and ETFs, which typically are highly diversified with hundreds of issuers. As bonds within the fund mature and coupons are paid, the earned interest can then be re-invested in newer higher-yielding coupon issues.

This adds more built-in flexibility to the fund while reducing some of the pressure of waiting for individual bonds to mature. In this scenario, yields don’t necessarily have to go back down for prices to return to par. Furthermore, given that investment-grade⁶ bonds have defaulted at a rate of just 0.10% since 1981 (most recently available data from Moody’s), the best time to invest in bonds could potentially be after a significant rate increase.

The “self-healing” feature of bonds may be even more pronounced with bond funds and ETFs, which typically are highly diversified with hundreds of issuers. 

What Constitutes a “High” Level of Rates Might Surprise You 

In early February 2022, the yield on the 10-year US Treasury note finally climbed back above 2.00% for the first time since July 2019. The pandemic hasn’t been the only thing keeping yields below 2.00%. In eight out of the past 10 years dating back to 2011, the 10-year note has been below 2.00% at some point during the calendar year, often for an extended period of time. Negative headlines—think Brexit, trade wars—have been known to trigger small bond rallies that help keep rates anchored below the 2.00% mark.

Current yields, in fact, are not all that far off from the levels seen when central banks embarked on numerous forms of quantitative easing in the aftermath of the GFC. For example, during the period from 2/1/13 to 2/1/22, the 10-year Treasury averaged 2.05%.

To be fair, time periods should be looked at individually for the factors that could spark higher rates. In today’s environment, inflation expectations are currently high due to the recent surges in the components that make up the Consumer Price Index⁷—it rose 7.5% in January 2022—and the supply-chain and labor bottlenecks that have received plenty of blame for the current inflation situation. Without a doubt, we’re in a different policy environment from what we experienced both after the GFC and the fiscal and monetary response to COVID-19. So, yes, the potential for higher long-term rates does exist. However, so does the potential for supply-chain bottlenecks to ease back to normal. Furthermore, the level of breakevens has not proven to be consistent with the level of interest rates (see FIGURE 3).  

While higher rates are probable at some point, the real problem lies in attempting to time fixed-income purchases based on interest rates.

Timing Rate Movements Consistently Is Difficult 

While higher rates are probable at some point, the real problem lies in attempting to time fixed-income purchases based on interest rates. Recent history illustrates just how quickly events can influence the market.

Example 1: In early 2016, the US 10-year Treasury yield stood at 2.27% and finished the year around 2.45%. Just looking at those beginning and ending rates, you might conclude not much happened that year. But in fact, something did. In a referendum in the summer of 2016, voters in the United Kingdom decided to break away from the European Union. The apparent potential for trade disruptions sent 10-year US Treasury yields tumbling dramatically to 1.36%, a midsummer low. By year’s end, yields had fully recovered (see FIGURE 4).

Example 2: By September 2018, the US Federal Reserve (Fed) had hiked rates seven times since 2016 and was about to raise them once more in December. By November 2018, the 10-year US Treasury yield reached as high as 3.23%—its highest point since May 2011. But by year’s end, the US-China trade war started heating up, and the S&P 500 Index ended the quarter losing more than 13%. After rising for nearly the entire year, the end-of-year yield in December 2018 had dropped to 2.69% in just over a month. Equity markets eventually recovered in 2019, but yields continued their steady march downward to below 2%—and had not been above 2% until recently.

Example 3: Despite the Fed’s commitment to accommodation in early 2021, rates rose rapidly with the 10-year benchmark hitting 1.74% by the end of the first quarter. Rates steadily declined through the summer, breaching 1.20% at one point, as the COVID-19 Delta variant appeared in the second quarter. As the variant continued to spread globally and vaccination rates failed to meet expectations, slowing growth became a concern. But rates once again turned higher in the fourth quarter as the Fed indicated the time was coming to begin tapering bond purchases. The 10-year ended the year at 1.49%.

The lesson: Attempts at timing the movement of rates have always proven extremely difficult. Public-health crises (e.g., pandemics) or geopolitical tensions abroad can present unforeseen risks that cause markets to swing wildly, one way or another, in a relatively quick period of time.

Bottom LineThe Fed indicated at their January meeting that it’s ready to soon begin raising the target range for the federal funds rate.⁸ Investors have already baked in their expectations for several short-term interest-rate hikes in 2022. Long-term rates sometimes follow suit, but not always. That said, the role of bonds in a portfolio remains the same: to help provide diversification in the event of an equity drawdown. In addition, while the recent uptick in rates may have caused some portfolio losses, the self-healing mechanism of bonds has historically rewarded patient investors over time.

Finally, even if you firmly believe rates are too low by historical standards, trying to time the buying and selling of bonds has almost always proven to be quite difficult. 

¹ The Bloomberg US Aggregate Bond Index is composed of securities from the Bloomberg Government/Credit Bond Index, Mortgage-Backed Securities Index, Asset-Backed Securities Index, and Commercial Mortgage-Backed Securities Index.

² The 10-year Treasury note is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate once every six months and pays the face value to the holder at maturity.

³ Break-even inflation is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality.

⁴ Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement. Example: a bond with a duration of 6 years could lose up to 6% for every 1% rise in interest rates. 

⁵ S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks.

⁶ An investment-grade rating signals that a corporate or municipal bond has a relatively low risk of default.

⁷ The Consumer Price Index is defined by the Bureau of Labor Statistics as a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

⁸ The federal funds rate is the target interest rate set by the Federal Open Market Committee (FOMC). This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.

Important Risks: Investing involves risk, including the possible loss of principal. Security prices fluctuate in value depending on general market and economic conditions and the prospects of individual companies. • Fixed-income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Diversification does not ensure a profit or protect against a loss in declining market.

“Bloomberg®” and any Bloomberg Index are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indices (collectively, “Bloomberg”) and have been licensed for use for certain purposes by Hartford Funds. Bloomberg is not affiliated with Hartford Funds, and Bloomberg does not approve, endorse, review, or recommend any Hartford Funds product. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to Hartford Fund products. 

The views expressed here are those of the author and should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams, and different fund sub-advisers, may hold different views and may make different investment decisions for different clients or portfolios. 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.