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

July 2021 chart July 2021: The low yield environment offered limited upside while still being exposed to meaningful negative returns in a rising rate environment.
Nov2023 Chart Today, bond portfolios offer meaningful upside potential and should act as a hedge against potential equity underperformance. Should rates continue to rise, the higher starting yield will serve as a counter to negative price movements, reducing downside risk.

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.

3 Q23 yield curve changes

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

Scenario 1

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

Scenario 2

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

Scenario 3

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

Scenario 4

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.


Learn the nuances of fixed income investing, including the risks, opportunities, and investment styles.

“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”). MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.

Any performance data shown represents past performance. Past performance is no guarantee of future results.

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The charts and graphs in this material are mathematical examples only and do not represent any Madison strategy. They assume bonds are held to maturity and experience no default, call or other credit event.

In addition to the ongoing market risk applicable to portfolio securities, bonds are subject to interest rate risk, credit risk and inflation risk. When interest rates rise, bond prices fall; generally, the longer a bond’s maturity, the more sensitive it is to this risk. Credit risk is the possibility that the issuer of a security will be unable to make interest payments and repay the principal on its debt. Bonds may also be subject to call risk, which allows the issuer to retain the right to redeem the debt, fully or partially, before the scheduled maturity date. Proceeds from sales prior to maturity may be more or less than originally invested due to changes in market conditions or changes in the credit quality of the issuer.

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Diversification does not assure a profit or protect against loss in a declining market.

Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only, and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance.

The Bloomberg Intermediate Govt/Credit Bond Index tracks the performance of intermediate term US government and corporate bonds.

A basis point is one hundredth of a percent.

Bond Spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, and risk, calculated by deducting the yield of one instrument from another.

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows.

Yield to Maturity (YTM) measures the annual return an investor would receive if they held a particular bond until maturity as of the end of a report period In order to make comparisons between instruments with different payment frequencies, a standard yield calculation basis is assumed This yield is calculated assuming semiannual compounding.