After more than thirty years of falling interest rates and thus rising bond prices, yields may be moving higher. While trends are often short-lived, this new trajectory could persist into 2017 and beyond given recent changes in the political landscape as well as a less accommodative Federal Reserve (Fed). We’ll take a look at what this new monetary and political environment may mean for bonds and how to best-position your fixed income portfolio for the long-term.
A proxy for the bond market, the 10-year Treasury note yield hit an historical low of 1.36% in July 2016 only to jump 100 basis points (or 1%) by the end of November. The move came as investors responded favorably to the surprise U.S. Presidential and Congressional election results, in anticipation of higher growth levels in the years to come.
Part of the optimism stemmed from the new administration’s promise to cut consumer and corporate taxes and spend on infrastructure projects. This picture presents a mixed bag for bonds, however. Increased fiscal spending and lower taxes are positive for economic growth and a healthy economy is generally good for lending and credit activity. But stronger economic growth would push yields higher and thus bond prices lower. On the other hand, higher yields would provide investors with higher current income, acting as a partial offset to lower bond prices. Rising interest rates or yields would also allow investors to reinvest into higher-yielding bonds.
Duration is an important characteristic to consider when reinvesting at higher yields. A bond’s duration is the length of time it takes an investor to recoup his or her investment. It also determines how much a bond’s price will fall when yields rise. Longer duration bonds such as Treasury or corporate bonds with long maturities experience sharper price declines when yields rise. Likewise, shorter duration bonds are less volatile and will exhibit smaller price declines, all else being equal. Because we can’t predict the exact direction or speed of interest rate changes, it’s important to have exposure to bonds with a mix of durations. In this way an investor is able to respond to any given environment. For example, when yields are rising, an investor can sell her shorter-duration bonds, which are less susceptible to prices changes, and reinvest into longer-duration bonds with higher rates.
Another factor that affects bond prices is inflation. Inflation expectations have started to heat up in light of low unemployment, wage growth, and expectations for increased government stimulus. Higher inflation could also put upward pressure on interest rates and thus downward pressure on bond prices. While inflation can erode the real returns of many bonds, some bonds, such as Treasury Inflation-Protected Securities (TIPS), stand to benefit. TIPS are indexed to inflation and backed by the U.S. government. Whenever inflation rises, the principal amount of TIPS gets adjusted higher. This in turn leads to a higher interest payment because a TIPS coupon is calculated based on the principal amount.
Finally, the Federal Reserve’s shift away from accommodative monetary policy will have an impact on bond prices. Although higher interest rates from the Fed will likely pressure fixed income prices, overall we view this change favorably. This is because a return to more normal interest rate levels is critical to the functioning of large institutions like insurance companies and banks, which play a key role in our society. Likewise, higher interest rates will provide more income to the millions of Baby Boomers starting to retire and would help stabilize struggling pension plans at many companies.
Taken altogether and in light of an uncertain environment, we believe a diversified bond portfolio targeted to meet your specific fixed income needs is the best way to weather this changing yield environment. In addition to considering your specific income objectives, our Investment Policy Committee meets regularly to assess the current economic, fiscal, and monetary environment. We adjust our asset allocation targets in order to take advantage of attractive opportunities or reduce exposure to higher-risk (over-valued) areas. While we may over-weight some areas or under-weight others, in the long-run we continue to believe that a well-diversified portfolio is the best way to weather any market environment.
The Parsec Team