Hello bond yields, my old friends.
I see you’re rising once again.
I’ll admit that most investors may not see the recent increase in yields as anything to sing about. Rising market yields mean falling prices for existing bonds. With the yield on the benchmark 10-year Treasury note flirting with 3% after starting off the year below 2.5%, it’s understandable that investors may be concerned.
10-year Treasury constant maturity rate
Source: Board of Governors of the Federal Reserve System (U.S.).
Investing in bonds when yields were falling
For at least the last 2 decades, 2 factors have driven investors’ return from investing in a bond. First, coupon payments (the annual interest you receive from the bond’s issue date to its maturity date) provided the annual return. Second, consistently falling market yields drove up bond prices.
For example, say you purchase a bond with a 4% annual coupon rate. If market yields are falling and newly issued bonds are offering only a 2% annual coupon rate, the demand for your bond increases, making it more valuable. (Of course, the opposite is also true.)
Things are different today—we’re seeing a return to historical norms. The vast majority of a bond’s return is determined by the yield at which it was purchased. Because yields are rising, bond prices are dropping, which means there’s less opportunity for additional capital appreciation.
A cyclical rebound
Will rates continue rising unabatedly? Probably not.
The U.S. economy is enjoying a cyclical rebound after a long down period that began with the 2008 global financial crisis. Secular forces—globalization, demographics, and technology—have restrained economic growth since the financial crisis. These forces, which aren’t dependent on economic conditions, remain in play, and they’ll ultimately limit the amount of tightening by the Fed.
The cyclical rebound other major economies are experiencing is providing global central banks an opportunity to remove monetary policy accommodations and raise rates. When several economies undergo a simultaneous cyclical rebound, they reinforce one another to some degree. This may present a risk to bond returns: If the Fed sees there’s enough economic activity (or detects significant signs of inflation), it may raise interest rates faster and higher than anticipated.
Look for positive economic conditions to support the health of corporate bond issuers and for interest rate risk (the risk your bond will lose value if interest rates rise) to remain moderate.
We don’t expect bonds to underperform relative to their long-term average results—we stand by our economic outlook for 2018, in which we forecast global fixed income returns in the range of 2% to 3% for the next decade. And although such returns may seem underwhelming, bonds are still an important part of a diversified portfolio because they can help offset equity market risk.
- All investing is subject to risk, including the possible loss of the money you invest.
- Diversification does not ensure a profit or protect against a loss.
- Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.