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Should Investors Worry About Rising Interest Rates?
Interest rates in the U.S. hit a one-year high recently, which may be hurting your portfolio.
Not only could your bonds lose value, as higher interest rates generally equate to lower bond prices, but your stock holdings may be battling headwinds in the face of higher rates.
Recently, the 10-year Treasury yield surged past 1.7% for the first time since January of last year.
Less than three months ago, it was below 1%. The move higher continues the trend that began last summer when the 10-year Treasury yield fell below 0.6%.
Before the coronavirus pandemic, the 10-year Treasury yield had seldom been below 1.5%, including during the Great Recession.
Although rates remain at historically low levels, their move higher has spooked many investors.
Volatility in the markets is the norm, but sometimes investors can exhibit short-term memory to their disadvantage. For example, going back to the outset of 2020, the 10-year Treasury yield was around 1.7%, which is where it is near today. There were obvious market gyrations at the outset of the coronavirus pandemic as interest rates tumbled. Understanding that markets are forward-looking, the move back in Treasury rates to where they were before the pandemic may not come as a great surprise.
Bond Bull Run
Whether investors use fixed-income in their portfolios as a defensive allocation or to capture yield, the returns in the bond market have been strong for a while. Over the past 15 years, the average annual return in the iShares 7-10 Year Treasury Bond ETF (ticker: IEF) has been about 4.8%. Over the last two years, the IEF logged a total return of about 10% in 2020 and 8% in 2019.
The IEF may be facing more headwinds today than it has in the recent past. Following the Great Recession, IEF faced similar headwinds. But during this time, the Federal Reserve had conducted multiple quantitative easing measures, providing an ultra-accommodative monetary policy environment. When the Fed was easing, IEF generally made gains, but following that period, the fund only gained an average of 1.8% per year between 2012 and 2018. This is well below its historical average.
It may be worth noting that some of the worst-performing years in the IEF have been 2015, 2016 and 2018. During those same years, the performance of the SPDR S&P 500 ETF Trust (SPY) was about 1.3%, 12%, and a loss of 4.6%, respectively. The correlation between markets is never that simple, but over the past decade, when bond markets have faced headwinds, so has the general stock market.
Richly Priced
The iShares 20+ Year Treasury Bond ETF (TLT) hit highs of more than $170 last year while the yield on the newly reissued 20-year U.S. Treasury bond fell below 1% for much of last summer. Understanding that the par value of a Treasury bond is $100, then investors were paying a very high price for this security. This is especially true when you consider the ultralow yield they were expecting to earn. Today, the price of TLT is closer to $135.
Many bonds hit record highs last year, but it is worth noting the 10-year Treasury yield has not been above 3.5% since 2011, and the 30-year Treasury yield has not been above 3.5% since 2014. It has been a while since the U.S. economy had to navigate through elevated interest rates.
Federal Reserve
The Federal Reserve has a mandate from Congress to promote maximum employment, stable prices and moderate long-term interest rates. Its mandate has shifted over the years, but seeking maximum employment certainly has increased expectations of lower rates for a longer period.
In February 2021, the U.S. unemployment rate fell to 6.2%. Although it hit 14.8% last April, this is still well above the 3.5% unemployment level from last January. Without a significant move lower in the unemployment rate, it may be unlikely that markets expect a sustained move higher in inflation because of higher interest rates.
As the economy continues to rebound from the depths of the COVID-19 pandemic, there may be reports of higher inflation, but it may also be transitory. The Federal Open Market Committee has shown a propensity to be accommodative and more focused on its mandate.
Takeaway
Interest rates have experienced a significant move higher since last summer, but these are also extraordinary times. Before the pandemic, Americans had rarely seen interest rates this low. As the economy continues to improve, expectations will be for a further rise in interest rates, but the pace going forward may be more subtle.
When markets move back to more normalized levels, they are usually met with investor uncertainty, which can cause volatility. After such an extraordinary period, this move back toward more normalized interest rate levels can also be a welcome sign for expectations on the future of the economy. After all, those who paid such high prices for a low-yielding security may want to put those days in the history books.
