Is there a way for bond investors to win if interest rates rise? We think laddering bonds is one way to navigate an uncertain and changing environment.

First, we must start with a simple fact. Nobody knows for sure what will happen to interest rates in the future. There are potential ranges of plausible outcomes, but in reality, the future direction of interest rates is unknowable. What is knowable is today’s level of interest rates. So, an investor interested in knowing the nominal dollar return of a T-bill or zero-coupon U.S. Treasury can know that future return with certainty today. This is not true for stocks and other fixed-income assets.

Once we move into other assets, we run into problems. The return of even a coupon paying Treasury bond can’t be known with certainty. Why? Because we don’t know the rate the coupon payments received along the way will earn. After all, the total return of an investment includes compounded return on cash flows received. Even though various yield calculations are made when the bond is bought, those calculations are imprecise. They include an assumption that coupons will be reinvested at the current rate. But future rates may be higher or lower, resulting in a higher or lower realized future return. The longer the final maturity of the bond, the more significant the impact of future reinvestment.

The Times They Are A-Changin’

Now that we see the first signs of inflation in years, we must talk about what a world of rising rates might mean for bond portfolios and how we address the risk. The chart below shows several things. The top green line shows an estimate of what the Treasury market thinks inflation might be in the years ahead. Notice that inflation is expected to be well above the 2-3% range in the next year or two. It is also assumed that inflation will then drift into the 2-3% range after year three and beyond. It must be noted that over the past decade, inflation ran near 1.5%. Thus, the expected pickup to 3-4% may appear shocking to some.

The other two lines show expectations for short-term interest rates in the years ahead. The Federal Reserve’s rate forecast is the blue dotted line, and the orange dotted line is the market expectation for rates (implied from forwards markets). Two things here are worth noting. One, expected short-term rates are dramatically lower than inflation, suggesting extreme monetary accommodation. Two, the market-based expectation is no longer in lockstep with the Federal Reserve. Markets seem to be anticipating that the Federal Reserve may need to raise rates sooner than previously expected.

Inflation and Short-Term Rate Expectations

Could interest rates need to be raised to head off inflation or reduce accommodation to prevent overheating the economy? This is a plausible outcome but not a widely accepted view at this point. As Bob Dylan said, the “times they are a-changin’” as government spending surges, tax policy is in flux, and central bank policy stays ultra-easy. But what if inflation does not come down as expected? What would this mean for bond investors?

Where Bond Investors Are Hurt Most

A portfolio of long-dated bonds would be hit hardest in the case of sharply rising interest rates. The longest of bonds, like a zero-coupon 30-year Treasury, would be hurt badly. A one percent rise in the interest rate would translate into a 25% decline in value, and a two percent rise would give way to a 44% drop in value for the bond. Thus, a very undesirable portfolio when rates rise would be a portfolio of long-duration bonds.

By contrast, a short-dated portfolio of bonds would tend to hold up relatively well. In fact, rising rates would help returns because as short bonds come due, new investments could be made at higher yields. Of course, the risk with this strategy is that inflation could come down, and rates fail to increase. If short-term interest rates don’t rise to meet inflation, an investor in only short-term bonds will suffer losses after adjusting for inflation.

The Sensibility of Laddering

After a long period of low interest rates, rising rates could give way to a better future for income-oriented bond investors. The key is to manage from today’s environment to that potential future environment. One reasonable way of getting from here to there, without owning either all long-dated or all short-dated bonds, is to ladder holdings.

A bond ladder consists of bonds with staggered maturities over a range of years. It does not attempt to position maturities around expected changes in interest rates. A ten-year ladder, for instance, owns bonds that come due each year over ten years. When the shortest bonds come due, the strategy reinvests proceeds in the long end of the ladder. This swapping automatically recycles from low-yield instruments to higher-yield instruments at the prevailing market price.

The advantage of this approach, especially during a period of rising rates, is flexibility. By recycling a portfolio into new bonds systematically over time, the portfolio yield automatically adapts to a changing rate environment. In the case of a ten-year ladder, half of the holdings will be replaced after five years. For a seven-year ladder, half are replaced in three and one-half years.

Unlike a portfolio of pure long-term bonds, a ladder has a significant advantage. Although higher rates may push down the price of longer bonds owned, higher rates result in a higher reinvestment rate for bonds coming due. This higher reinvestment rate allows flexibility for the portfolio to adapt to higher rates. A long-dated zero-coupon Treasury would need to wait decades for losses to be made up. Unlike a portfolio of pure short-term bonds, a ladder also has a significant advantage when interest rates are uncertain. This is because a ladder, in contrast to pure short-dated portfolio, allows for higher interest rates to be earned in the near term should interest rates fall or stay the same, or if rates take longer than expected to rise.

What Now?

It will take time for the economy to clear supply shortages and surging demand during the expected “reopening.” However, the 30% surge in money supply during the pandemic, plans for significant expansion of government spending under the Biden administration, and unprecedented monetary accommodation raises longer-term uncertainties that will take time to understand. Coming legislation will clarify some of the more critical, long-lasting issues about spending and taxes. Until then, we must consider all possibilities for the future path of interest rates and what it means for portfolios. We still think that much of today’s inflation pressure will subside, but it is unclear what the landscape for inflation and interest rates look like in a post-COVID-19 world.

So as you can see, we may be at an inflection point, so it is important to have this discussion about inflation, interest rates, and fixed income strategy now. Bond investors will do well by learning about options to invest in an uncertain environment. We think bond laddering is a sensible and practical way to invest the fixed income part of a balanced portfolio given uncertainties that lie ahead.

Disclosures:

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