What bond investors should do as interest rates rise

The quarter happily about to end provided a lesson in the eternal truth that governs the bond market: when yields go up, prices go down, which they have historically done.

Yields are up sharply since the start of the year, extending losses that actually date back to early 2021. Since then, the Bloomberg Global Aggregate Bond Index has posted a negative total return of around 11%, which amounts to $2.6. trillion, eclipsing the $2 trillion loss suffered in 2008 during the 2007-09 financial crisis.

From the start of the year through Thursday, the benchmark 10-year Treasury yield rose 86.1 basis points (1/100th of a percentage point), to 2.375%, the highest level high since May 2019. The lion’s share of that surge—54.7 basis points—occurred in March, as debt markets accepted the start of the Federal Reserve’s long-awaited (and arguably belated) reversal of its super accommodative monetary policy. This position was taken during the disastrous days of the economic and financial market collapse of March 2020 under the effects of Covid-19 – and has been maintained until recently, despite the vigorous recovery of the economy and the flight from inflation, with consumer prices rising 7.9% in the past 12 months to a four-decade high.

It may not be a coincidence that the 10-year Treasury yield broke above its descending trend line that was dating back to the all-time high of more than 15%, reached in September 1981, according to Evercore ISI. And should the benchmark return above 3%, its 2018 high, that would still signal a breakout, according to a report from the firm’s avid chartist Rich Ross.

What happened to bond investors is bad enough. the

iShares Core US Aggregate Bond

The listed index fund (ticker: AGG) posted a negative total return of 5.77% year-to-date through Wednesday, Morningstar reports. It was only slightly less than the

SPDR S&P 500

(SPY) negative 6.27%. This means that the fixed income portion of a balanced portfolio failed to offset the decline in equities. the

Vanguard Balanced Index Fund

(VBAIX), which follows the classic combination of 60% stocks and 40% bonds, posted a negative return of 6.50% over the same period.

The silver lining, according to a research note by Bank of America analyst Ralph Axel, is that the surge in Treasury yields effectively discounted the Fed’s expected tightening campaign. In particular, the yield on the two-year note has nearly tripled since the end of 2021, jumping 140.5 basis points, to 2.135%, through Thursday, with about half the increase in March. The five-year Treasury yield is up 112.9 basis points to 2.395%, putting it above the benchmark 10-year note.

Based on forward transactions, the Fed’s key rate – the federal funds rate – is expected to end the year in a range of 2.25% to 2.50%, according to CME Group’s FedWatch site. That would include 50 basis point hikes at the Federal Open Market Committee meetings on May 3-4 and June 14-15, rather than the 25 basis point moves that have been the rule in recent years. It would also be well above the median forecast of 1.90% in the FOMC’s summary of economic projections, released on March 16 only.

But an array of Fed speakers, led by Chairman Jerome Powell, are calling for more assertive action if needed to contain inflation. The futures market now forecasts a mid-2023 peak of 2.75% to 3% for the fed funds target, up from 2.50% to 2.75% at the end of the previous week.

James Kochan, the former fixed-income strategist for the Merrill Lynch and Wells Fargo funds and a market veteran who was there for all-time highs in yields, thinks rates will rise much more than that. In particular, given the good dynamics of the economy, he doubts that rates of 2 to 3% will cause a slowdown, even if inflation falls to 5%.

Much of the expectation of a peak in rates, and by extension the economy, is tied to the yield curve. A narrower spread between short- and long-term interest rates has always been a harbinger of a slowdown, and the narrow 20 basis point spread between two- and 10-year Treasury yields has sparked fears of recession.

But the central bank’s massive purchases of Treasury and agency mortgage-backed securities, which doubled the size of its balance sheet to nearly $9 trillion, artificially lowered long-term yields. Michael Contopoulos, director of fixed income at Richard Bernstein Advisors, says the 10-year yield would be closer to 3.70% without this quantitative easing. Thus, he argues, the signal of yield curve recession is distorted.

Kochan says he sticks to his recommendation of the past two years: bond investors should be in the short-duration sectors of the high-yield market, where current earnings could offset price declines. He would avoid treasury bills and municipal bonds of longer duration. “I prefer to assume some degree of credit risk rather than interest rate risk,” he wrote in an email.

Cliff Noreen, head of global investment strategy at MassMutual, agrees. While corporate spreads (the extra yield increase for credit risk) have widened somewhat this year, he finds that the fundamentals of high-yield issuers are generally strong, with solid earnings, high margins and reasonable leverage. The outlook for downgrades and defaults is also favourable.

Variable rate business loans are among the most attractive sectors, Noreen said in an interview. Their yields should be improved with further rises in the short-term rates on which loans are based, such as Libor (the London interbank offered rate) and its successor, SOFR (the guaranteed overnight funding rate). MassMutual favors this asset class for its policyholders, he added in an email.

Individual investors can gain exposure to the sector through an ETF, such as

Senior Loan from Invesco

(BKLN) or closed-end funds, which I have often highlighted, most recently in January. These CEF loans are cheaper today, mainly due to a widening of their discounts relative to net asset values, which have fallen only slightly.

In the muni market, short-term yields have also increased significantly, making it an attractive alternative to cash holdings that still only yield a fraction of a percent. For example, a tax-free two-year triple-A muni yields 1.62%, making it an attractive alternative to the comparable Treasury bill for investors in federal tax brackets above 24%.

But some new issues offer better relative returns, observes Kyle Gerberding, director of trading at Asset Preservation Advisors, an Atlanta-based muni specialist. He points to a Texas Permanent School Fund bond for Lamar, Texas, with a 5% coupon maturing in 2027, priced at a premium to yield 1.98%, or 84% of comparable Treasury. Texas PSF bonds have a triple A rating and were described by our colleague Andrew Bary three years ago as the ultimate safe investment.

Even though the bond market has been hit hard this year, yields could still rise, generating more losses. These relatively defensive and shorter duration alternatives offer some yield to help weather the turbulence ahead.

Read more from top to bottom of Wall Street: If the Fed pulls that back, it’s party time

Write to Randall W. Forsyth at [email protected]

Leslie M. Gill