By Wes Crill PhD, Head of Investment Strategists and Vice President, 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. 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 NZ$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 NZ$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.
Markets quickly incorporate new information about higher interest rates and inflation.
Investors who maintain appropriate asset allocations, even after increases in bond yields, may have a more rewarding investment experience in the long run.
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.
Highgate Partners Limited believes the information in this publication is correct, and it has reasonable grounds for any opinion or recommendation found within this publication on the date of this publication. However, no liability is accepted for any loss or damage incurred by any person as a result of any error in any information, opinion or recommendation in this publication.
Nothing in this publication is, or should be taken as, an offer, invitation orrecommendation to buy, sell or retain any investment in or make any depositwith any person.
The information contained in this publication is general in nature. It may not be relevant to individual circumstances. Before making any investment, insurance or other financial decisions, you should consult a professional financial adviser.
This publication is for the use of persons in New Zealand only.
You must not reproduce or distribute content from this publication or any part of it without prior permission.
Dimensional Fund Advisors Disclosures
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.
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.
This material is issued by DFA Australia Limited (incorporated in Australia, AFS License No. 238093, ABN 46 065 937 671). This material is provided for information only. This material does not give any recommendation or opinion to acquire any financial product or any financial advice product, and is not financial advice to you or any other person. No account has been taken of the objectives, financial situation or needs of any particular person. Accordingly, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. Investors should also consider the Product Disclosure Statement (PDS) and for the Dimensional Wholesale Trusts the target market determination (TMD) that has been made for each financial product or financial advice product either issued or distributed by DFA Australia Limited prior to acquiring or continuing to hold any investment. Go to dimensional.com/funds to access a copy of the PDS or the relevant TMD. Any opinions expressed in this material reflect our judgement at the date of publication and are subject to change.