Theoretical bond math shows that when rates rise, bond values decline. But reality isn’t so simple.
“The Fed only directly controls short-term rates,” Ritchie Tuazon, principal investment officer of American Funds Strategic Bond FundSM says. “That means rate hikes should have an outsized impact on shorter maturity bonds. Put another way, the shorter term part of the Treasury yield curve should rise more than the longer term. This would indicate a flattening of the yield curve, which tends to happen when the Fed tightens policy.”
Bonds of varying maturities see different effects from rate increases. Consider the last four periods of hikes. The Bloomberg U.S. Aggregate Index, the prominent benchmark for core bond funds that features a mix of high-quality issues across sectors and maturities, has only had a negative return once, while the average return over those periods was 3%.
Selectivity matters. “Actively managed bond funds can position portfolios to focus on certain parts of the yield curve,” Tuazon explains. “We can avoid bonds that we believe will be more adversely affected by rising rates. We can also aim to mitigate inflation risk by purchasing Treasury Inflation-Protected Securities (TIPS).” TIPS are linked to the Consumer Price Index, so they have the potential to outpace nominal Treasuries in periods of rising inflation.
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