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

By Thomas Meinke & Wes Crill, PhD of Dimensional Fund Advisors

Investors have likely noticed the improved opportunity set in fixed income due to higher yields. And yet some investors may be hesitant to take advantage of higher yields because of concerns about future increases in yields. Some may even be considering reducing their bond exposure after this year’s negative returns for fixed income.1

The good news? If yields do keep rising, investors seeking higher expected returns may still
be better off maintaining the duration of their fixed income allocation. Rising yields impact fixed income portfolios in several ways.

On the one hand, longer duration portfolios may experience larger immediate losses from increased yields relative to shorter-duration portfolios. On the other hand, higher yields may lead to higher expected returns.

Investors can think of this tradeoff as a pit stop in a Formula 1 race. The pit stop immediately causes the driver to fall back. However, fresh tires may help the driver win the race if there are enough laps left to catch the leader.

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.

When faced with uncertainty, investors should focus on the things they can control. Research tells us that trying to outguess the market by holding on to cash, or shortening duration, with the expectation of future yield increases may not help you achieve your long-term goals. 2

Markets quickly incorporate new information about higher interest rates and inflation. 3

Investors who maintain appropriate asset allocations, even after increases in bond yields, may have a more rewarding investment experience in the long run.

Important Disclosures


Fixed income securities are subject to increased loss of principal during periods of rising yields.
Source: Dimensional.

Data presented are based on mathematical principles, are not representative of indices, actual investments, or actual strategies managed by Dimensional, and do not reflect costs and fees associated with an actual investment. Growth of wealth assumes a constant duration and flat yield curve for simplicity.
For Scenario 2, the approximate 15% drop in value seen in year 0 is based on a hypothetical yield increase from 1% to 4%, resulting in an immediate decline in value. The drop in value can be approximated by multiplying the assumed five-year duration by the yield increase.


For illustrative purposes only.

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.

  1. The Bloomberg Global Aggregate Bond Index (hedged to USD) returned –12.1% from January 1, 2022, through September 30, 2022.
  2. Mingzhe 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.
  3. Wes 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.

The information in this material is intended for the recipient’s background information and use only. It is provided in good faith and without any warranty or representation as to accuracy or completeness. Information and opinions presented in this material have been obtained or derived from sources believed by Dimensional to be reliable, and Dimensional has reasonable grounds to believe that all factual information herein is true as at the date of this material. It does not constitute investment advice, a recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. Before acting on any information in this document, you should consider whether it is appropriate for your particular circumstances and, if appropriate, seek professional advice. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized reproduction or transmission of this material is strictly prohibited. Dimensional accepts no responsibility for loss
arising from the use of the information contained herein. This material is not directed at any person in any jurisdiction where the availability of this material is prohibited or would subject Dimensional or its products or services to any registration, licensing, or other such legal requirements within the jurisdiction.
“Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd., Dimensional Japan Ltd. and Dimensional Hong Kong Limited. Dimensional Hong
Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services. 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.

Risks
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.

UNITED STATES
Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.


Investment products: • Not FDIC Insured • Not Bank Guaranteed • May Lose Value
Dimensional Fund Advisors does not have any bank affiliates.