It's no secret that we are now entering a new cycle in global interest rates. The world economy is progressively showing more signs of a positive turn and a number of key central banks are now on the path of carefully transitioning away from the accommodative conditions that have dominated the post-GFC era. Case in point: the US Federal Reserve raised rates in December 2017 and is expected to hike rates a few more times over the course of 2018.
Astute investors will also know that if interest rates rise, bond yields increase. And if bond yields increase, bond prices must fall. And it's this concept that has many bond investors spooked.
We often forget, however, that investing in bonds generates two forms of investment returns: capital returns from changes in the bond price and income returns from regular bond coupons.
Crucially, the 'income' in fixed income actually drives a significant part of total bond returns over the long term and acts as an effective cushion against shorter-term volatility in bond prices. Consider the composition of total bond returns as represented by the Bloomberg Barclays US Aggregate Index:
Don't neglect the 'income' in fixed income!
So how can rising rates be good for bond investors? For those invested in a bond fund, rising rates equals higher income as bond coupons reprice higher and cash gets reinvested at the higher bond yields, thereby lifting the 'income' component of total bond returns. And there is potentially more value added if the bond fund is actively managed for interest rate risk (i.e. duration) as this helps to reduce adverse changes in bond prices during the transition and limits the downside in the 'price' return component of total bond returns.
In the long term, total returns are all about the income…don't neglect the 'income' in fixed income!
Senior Portfolio Manager,