Why higher interest rates are ‘the single best economic development’ for investors in the past 20 years

Assets in funds globally swelled back to 2021 levels this year, but this was largely due to asste price rises and the popularity of bond funds,

Given the impact of higher interest rates on slowing the global economy, you’d be forgiven for thinking there was little to cheer about interest rates settling at a higher level – but that’s exactly what one of the world’s largest investment platforms is arguing.

According to Vanguard, the recent rise in interest rates is the “single best economic and financial development” in the past two decades.

In its 2024 investment outlook, the investment adviser predicted that rates were not going to fall back to zero, meaning real interest rates would remain in positive territory as inflation continues falling.

This is good news for investors in bonds, Vanguard said.

Although a period of rising interest rates knocks bond prices, a period of higher interest rates offers investors greater returns.

Increases in real interest rates “provide a solid foundation for long-term risk-adjusted returns”, Vanguard said.

It predicted that UK bonds would return somewhere between 4.4 per cent and 5.4 per cent in the next decade compared with between 0.8 per cent and 1.8 per cent before the rate rise cycle began.

If the income from bond returns is reinvested at this level, then the income from higher rates will “more than offset” the losses experienced over the past two years, Vanguard said.

“By the end of the decade, bond portfolio values are expected to be higher than if rates had not increased in the first place,” the report said.

It recommended that investors stock up on bonds as opposed to equity, as equity markets are yet to “fully reflect the implications” of higher rates.

However, it warned that there’s potential for “near-term financial market volatility” as the transition to higher rates is not yet complete.

The global economy has already seen financial volatility due to the impact of higher interest rates, including the collapse of Silicon Valley Bank and the LDI crisis in the UK.

Further instability could yet emerge, particularly in the relatively lightly regulated shadow banking sector.

But Vanguard was sanguine about the risks. “Despite the potential for near-term volatility, we believe this rise in interest rates is the single best economic and financial development in 20 years for long-term investors,” the report said.