"Interest rates have nowhere to go but up!" That's the tune Wall Street's prognosticators have been singing over the past five years, and they've been dead wrong. Until now.
After hitting a yearly bottom of 1.63% on May 1, the yield on 10-year U.S. Treasuries (IEF) recently zoomed ahead to near 2.6%. Investors who own individual bonds or a bond fund will likely have seen something unfamiliar in their mid-year statements: bond value losses.
What's your game plan for hedging investment clients against higher interest rates?
Steeper Yield Curve
This year's rout in bond prices has done more than just raise interest rates; it's also increased the yield curve.
As the yield curve steepens, the difference or spread between long-term and short-term interest rates increases. This causes long-term bonds to decrease in value relative to bonds with shorter maturities.
Many pundits and economists theorize a steepening yield curve is good for the economy, as it's a sign of future growth and inflation. One justification they provide is that the steeper curve is great for banks (XLF) because they make their money on the net income margin.
Another popular argument is that a rising yield curve suggests an improving economic climate. Business Insider recently wrote, "When yields are rising from a low level, they reflect improving prospects for economic growth." Maybe in theory, but a glance at reality suggests otherwise.
Higher interest rates have already taken a toll on mortgage activity. The weekly refinance index has fallen by more than 50% since early May, according to the Mortgage Bankers Association. Likewise, other rate sensitive sectors like REITs (VNQ) and Utilities (XLU) have pulled back.
For perspective, the chart nearby shows the historical yield spread between 10-year Treasury yields and the federal funds rate (FFR). The yield spread between both benchmarks has never been more than 400 basis points or 4%. And today, with 10-year yields now around 2.6% and the FFR between zero and 0.25%, the 10-year yield would need to shoot up to 4.35% to break historical records. That leaves a potential 1.85% upside in 10-year yields, should the FFR hold steady and should rate relationships stay within their historical limits.
Rebalancing Needed
As bond yields rise, bond prices fall. Because of their sensitivity to rate spikes, long-term bonds and Treasuries have fallen the hardest. The iShares Barclays 20+Yr Treasury ETF (TLT) has declined 10% since early May.
Conversely, ETFs that own Treasuries with shorter maturities like the Vanguard Short-Term Government Bond Index Fund (VGSH) and the PIMCO 1-5 Year U.S. TIPS (STPZ) have declined less than 2%. The value of bonds with shorter maturities is less impacted by rising rates.
"Fixed-income investors should be particularly cognizant of liquidity levels, keeping maturities short and spread duration low. High-yield spreads may widen by another 100 basis points because of the recent Treasury crash," said Scott Minerd, Guggenheim Partners' global chief investment officer.
Because long-term U.S.Treasuries have been star performers ever since the 2008-09 financial crisis, many bond investors piled into them chasing higher returns and higher yields. Treasury prices have been further inflated by the Federal Reserve's Treasury purchases via "QE" or "quantitative easing."
