The return of total

Bond investors have a dichotomy hammered into their heads: prices rise when yields fall, and vice versa. Until recently, the Wall Street Journal even appended this phrase at every mention of a yield: “which rises when bond prices fall.” But that two-part mathematical truism is only half the issue. The onset of the Federal Reserve’s easing cycle in mid-September brings renewed attention to the two factors that comprise total return.

The total return of a bond or fixed-income fund measures the overall gain or loss over a period and is commonly expressed as a percentage. It is comprised of two different, but related elements: the income, generated by the predetermined amount of the coupon payments, and changes in the security’s price. Generally, when the Fed is raising rates, the existing bond prices fall, though newly issued bonds typically reflect the increase with higher coupon yields, benefiting investors. The opposite occurs when the Fed is lowering rates as fixed-income total returns benefit from the favorable price action and still elevated coupon. We are in the latter environment, so this dynamic means fixed-income securities are now especially attractive.

We anticipate that U.S. Treasury notes with maturities within one-to-five years will be the most reactive to rate cuts, meaning most likely to provide positive total return. Bonds with maturities longer than this tend to respond to elements in addition to monetary policy actions, such as risks related to the U.S. budget deficit, political issues, inflation, and geopolitical tensions, among others.

What about duration? This measure of a security’s price sensitivity to changes in interest rates also plays a large role in the calculation of a bond's value. The longer a security’s duration, the more its price fluctuates when rates increase or decrease. Duration considers time to maturity and coupons. A bond with a longer maturity has a higher duration relative to one with a shorter maturity. In turn, a security with a higher coupon has a lower duration than one offering a lower coupon. Other factors can play a role in the Treasury market, such as a sudden flight-to-safety trade. But the extent to which the Fed continues to ease rates, and considering credit quality, investors should benefit from extending the overall duration of one's fixed-income portfolio. 

This rotation to stronger bond performance actually began prior to the first rate cut and is likely to persist as additional cuts occur. Each monetary policy cycle varies, but the pattern appears to be in place for the current one, potentially benefitting investors who have shifted into longer-dated fixed-income securities, mutual funds and ETFs. As we pass through the remainder of the year and gain a better understanding of the Fed’s path, as well as the policy outcomes of the elections, leaning toward longer duration approaches, such as intermediate and core fixed-income, has the potential to an be an overall—and total—positive.