Yield Curve Scenario Analysis: Using Duration and Bond Math to Measure Return Potential

Bond Concepts by Madison Investments

It has been a challenging environment for bond investors recently. After suffering through nearly 15 years in which income was scarcely available due to the Federal Reserve’s policy of keeping rates artificially low, losses began to mount when the Fed changed course. The largest repricing of fixed income assets in generations resulted in deep negative returns. Now, with the 10-year Treasury testing 5% and the Fed indicating that interest rates may be approaching their peak for this cycle, investors are asking what returns in the bond markets might look like going forward.

Bond Math Finally Looks Easy

To demonstrate the total return potential of fixed income, let’s analyze interest rate sensitivity. In simplistic terms, as yields rise, the price of a bond falls. As yields fall, the price of a bond rises. In today’s yield environment, where typical high-quality intermediate bonds yield 5%, the return scenarios are greatly improved compared to just a short time ago.

Then vs. Now

While the above analysis does a great job of showing how drastically the risk/reward relationship in bonds has swung in an investor’s favor – reduced downside risk and dramatically improved upside potential, it has a drawback. It answers a simple question too simply. It assumes all bonds across all maturities change by the same amount. In reality, this rarely, if ever, occurs. As rates change, the yield curve twists, producing differing returns within different maturity ranges. Just look at the yield curve changes from the third quarter of 2023.

Calculating Forward Total Return Potential in Fixed Income

A more realistic way to analyze the likely path of future returns is through scenario analysis. Come up with an economic scenario, develop a thesis on how the yield curve might react, and reprice your portfolio based on that new rate environment. In this analysis, we assume the yield curve changes were instantaneous, and we did not incorporate any spread changes between asset classes. But if asked what might happen to a portfolio if rates rise or fall, this analysis should represent a much better estimation than a simple up/down chart can provide.

The following tests four potential economic scenarios that may play out over the next 12-18 months: status quo, the economy remains strong, we experience a soft landing and a hard landing. We used the Bloomberg Intermediate Government/Credit Index and its current mix of maturities in our analysis.

Scenario 1: Status Quo

If interest rates remain at their current levels throughout the curve, a portfolio’s return would roughly equal its yield to maturity.

Index Yield to Maturity: 5.35%
Expected Price Return: 0.00%
Expected Total Return: 5.35%

Scenario 2: Economy remains strong

If the economy remains strong and inflation remains elevated or even accelerates, the Fed may have to hike rates further. This would likely result in the entire yield curve shifting higher.

Index Yield to Maturity: 5.35%
Expected Price Return: -2.72%
Expected Total Return: 2.63%

Scenario 3: Soft landing

In a soft landing scenario, where the economy and inflation decelerate gradually, the Fed would return to a more neutral interest rate policy and the yield curve would normalize. This follows the Fed’s dot plots, with the Fed Funds rate at 4% and ten year at 4.5%.

Index Yield to Maturity: 5.35%
Expected Price Return: 2.34%
Expected Total Return: 7.69%

Scenario 4: Hard landing

In a hard landing scenario, the Fed would need to cut rates significantly to stabilize the economy, which would result in much lower rates and a steeper yield curve.

Index Yield to Maturity: 5.35%
Expected Price Return: 6.18%
Expected Total Return: 11.53%

Whether you are looking at a simple up/down rate change or analyzing a more realistic set of yield curve scenarios, the math is clear. The income that has returned to a fixed income portfolio provides investors with additional cushion should interest rates continue to rise but also offers the potential for price appreciation.