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

Rising rates have a variety of effects on fixed income portfolios. One the one hand, increasing yields may cause longer-duration portfolios to suffer more immediate losses than shorter-duration portfolios. On the other side, greater yields can result in greater anticipated returns. This tradeoff can be compared to a pit stop in a Formula 1 race by investors. The driver initially falls back after the pit stop. However, if there are enough laps left to overtake the leader, new tires could actually help the driver win the race.

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. 

Investors should concentrate on the factors within their control when faced with uncertainty. According to research, trying to time the market by keeping cash on hand or reducing duration in the hope of higher yields in the future won't necessarily help you reach your long-term objectives.¹  New information about rising interest rates and inflation is quickly incorporated by the markets.² Long-term returns on investments might be higher for investors who keep suitable asset allocations even as bond yields rise.

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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.

¹Mingzhe Yi, “All Eyes on the Fed? A Look at Federal Funds Rate, Bond Return, and Term Premium,” Insights (blog), Dimensional Fund Advisors, March 15, 2022.
²Wes 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.

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Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, call risk, and other factors. There is no guarantee strategies will be successful.

Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.