Rising Rates and Bonds - Short term pain for long term gain?

Rising Rates and Bonds - Short term pain for long term gain?

It makes a change for bond markets rather than stock markets to be grabbing the headlines as has been the case in recent weeks.  Perhaps the media should pay more attention given that the global credit market is approximately three times the size of its more popular relation and at least as important.

It is no secret that this year so far has been a very unusual one with global and domestic economic conditions causing a downwards movement in both stock and bond prices at the same time.

Bond prices are directly affected when interest rates rise (or when raised faster than the markets anticipated).  The longer the term of the bond, the more that the price is affected. 

There is evidence to support having only shorter dated bonds in a diversified portfolio with their more benign nature acting as a counterweight to water down the fieriness of the stocks.  Other evidence points to the benefits of having more duration risk which increases expected long term risk adjusted returns when combined with stocks. 

We have long studied each approach and have concluded that both have merit.  This is one of the (many) reasons why we have adopted a two-pronged approach within our portfolios to incorporate both ideas on this specific and important element of portfolio construction.

So far in 2022, Vanguard (who incorporate more duration risk) have felt the pain of the interest rate moves more keenly than Dimensional (who have less duration) and this has been a contributor to the performance differential so far in 2022.  This follows a significant period of Dimensional’s fund lagging behind that of Vanguard.  2022 has shown that our rationale for diversifying these two differing approaches is a sound one. 

So what might happen next?  Some assume that further interest rate rises are inevitable (we would avoid such predictions) and therefore those with longer dated bonds will fare the worst.  However, the outcome of such a scenario is not necessarily what you might think, as this excellent three minute read from our colleagues at Dimensional shows.