The other interesting element of the table above relates to the total returns for the two years over each of the previous tightening cycles. While the duration and starting yield levels of each tightening period differ greatly, the total returns from each period are remarkably similar at approximately 3%. In higher-rate environments, the duration of the tightening cycle has historically been shorter. In the most recent tightening cycle, from 2003 through 2006, the longer period of tightening allowed bond investors to recoup losses through higher levels of income.
While we don’t anticipate that the pace of Fed tightening will be as aggressive as the periods seen in recent history, we do believe that in each previous period, the market underestimated the timing of a shift in policy. However, during previous periods, starting yields were significantly higher, thus increasing bond investors’ margin of error. In our view, given the current low levels of income potential, the prospect of negative returns from short-duration fixed income remains at much higher levels than in past tightening cycles.
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1Source: Jens H.E. Christensen and Simon Kwan, “Assessing Expectations of Monetary Policy,” Federal Reserve Bank of San Francisco, 9/8/14.
2Source: Bloomberg, as of 8/31/14.
3Source: Morgan Stanley, 6/9/14.
4Sources: Bloomberg, WisdomTree.
Important Risks Related to this Article
Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. In addition, when interest rates fall, income may decline. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.