How Do Rising Interest Rates Affect Investment? The Future of Bond Investing and Diversification

In the first part, we organized past trends in bond yields and explained the background behind them.

In this second part, we will explain in an easy-to-understand way how the current trend of rising interest rates affects the performance of bond ETFs (Exchange Traded Funds) invested in through WealthNavi. We will also explore the “new role” that bonds play in global “diversification.”

Focusing on Returns from “Distributions” in Bond ETFs

The bond ETFs that WealthNavi invests in provide not only returns from daily price fluctuations but also “distributions” that can be received periodically.

The distributions of bond ETFs are primarily funded by the “interest (coupons)” paid periodically by countries and companies. Compared to equity ETFs, which include non-dividend-paying growth companies or low-dividend companies, bond ETFs are characterized by the fact that “distributions account for a large portion” of total returns.

Here, we will look at the cumulative figures for “returns from price changes” and “returns from distributions” since September 2003, when the representative bond ETF that WealthNavi invests in, the “iShares Core U.S. Aggregate Bond ETF (AGG),” was launched.

While there are some years where there are ups and downs in a single year, it can be seen that the distribution returns accumulated over many years support the growth of the entire asset.

In other words, not only visible price fluctuations but also the distributions generated periodically are important elements for growing assets over the long term.

Distribution Returns Are Linked to Interest Rate Levels

In fact, the distribution yields of bond ETFs like AGG tend to move in tandem with global interest rate levels (such as long-term U.S. Treasury yields).

This is because when interest rates rise, the interest on newly issued bonds is set higher, and the prices of already issued bonds fall, which relatively improves the yield (the ratio of interest income to the investment amount).

Let’s compare the past trends of U.S. long-term interest rates and AGG distribution yields.

Looking back at the data since the launch of AGG in 2003, we can confirm a trend where distribution returns also tend to rise with a slight delay after global interest rate levels increase (*).

*The above content is an example based on past performance, data, etc., and does not guarantee future investment results.

In other words, the global rise in interest rates occurring currently can be viewed positively as “an attractive environment where higher distribution returns can be expected from bond ETFs than a few years ago.”

From “Defense” to “Returns.” Diversified Investment That Incorporates Global Changes

The rise in bond interest rates occurring in major developed countries may increase interest income from individual bonds and act as a tailwind to boost distributions for bond ETFs like AGG that invest in them. Therefore, the investment environment can be described as “more positive regarding bond investment than before.”

During the low-interest-rate era from the late 2010s to the early 2020s, bonds were primarily recognized as a “cushion to soften the shock of stock market declines (defensive assets)” and were not recognized as assets that generate large returns.

However, now that interest rate levels have improved significantly, bonds are changing into assets that can be expected to provide returns in addition to their function as a cushion to suppress portfolio risk.

Just as it was difficult to accurately predict the current rise in interest rates a few years ago, it is impossible even for professionals to perfectly foresee the future market environment.

That is precisely why what is important is “diversified investment,” which involves continuing to invest broadly in diverse assets such as stocks and bonds based on one’s own risk tolerance, without being biased toward specific assets or temporary trends.

The current environment, where bonds have become a more reliable presence, can be considered a positive situation for investors who continue diversified investment and for WealthNavi.

Written by: WealthNavi Inc. Research & Quant Team

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