Changes in Bond Yields

The recent increase in bond yields and the likelihood that the Federal Reserve will begin raising its target rate later this year have elevated investor concerns. Many investors are wondering if this is the beginning of a continued increase in yields and, if so, how it will affect their bond portfolios. From the end of January, the benchmark 10-year Treasury rate increased from a low of 1.64 percent to 2.37 percent in mid-June. While this rate is still low from a historical perspective, it is a fairly large increase for a short time frame.

Reasons for the Recent Increase

The Federal Open Market Committee (FOMC) has had a very accommodative monetary policy to help boost the economy out of the deep recession. It has held short-term rates near zero for almost seven years. We are, however, beginning to see signs of sustained improvements in economic data. New jobs numbers have come in better than expected. Nonfarm payroll employment has exceeded the 200,000 threshold in 14 of the past 15 months. As U.S. inflation data stabilizes, it is expected we will begin to see a rise in the target rate later this year.

The U.S. is not alone when it comes to the recent increase in benchmark interest rates. Many European government bonds have witnessed the same rate increases. The German 10-year Bund hit a low of 0.07 percent on April 20. It has since increased to 0.90 percent in less than two months. Although it is still an extremely low rate, it is a dramatic increase for such a short time frame.

Is This the Beginning of a Sustained Rise in Yields?

We believe it is nearly impossible to forecast the direction of future interest rates. There are many factors that could cause rates to continue their ascent or to fall back to lower levels:

• As mentioned, it is expected that short-term rates will increase, but this does not mean there will be an increase of 25 basis points at every FOMC meeting. The increase could be gradual because the Fed does not want to increase rates too fast and risk slowing the recovery.
• Further, an increase in short-term yields does not mean that all points of the yield curve will increase at the same rate. Short-term rates could increase at a rate greater than longer-term rates, causing a flattening of the yield curve.
• The current yield curve has already priced in an increase in rates. Investors are being compensated with higher yields for extending maturities. The question we do not know: Will yields increase faster (or slower) than what has already been priced into today’s market?

What Has Been the Effect on Bond Returns?

When interest rates go up, bond prices go down. For the first month of the year, bond yields had a fairly dramatic descent. The 10-year Treasury fell from 2.17 on December 31 to 1.64 percent at the end of January. This was good for bond prices. Since then, rates have jumped; the 10-year Treasury sat at

2.37 percent in mid-June. While this is a big jump from the January low, it is hardly a significant change from the start of the year. This places the year-to-date returns on bond indices nearly flat. The Barclay’s Capital Short and Intermediate-Term Treasury Index are still up for the year at 0.46 and 0.39 percent, respectively. The Barclay’s 5-Year Muni index is down just 0.02 percent year to date.

Our Message Has Not Changed

For investors who have followed our general guidance to use short- to intermediate-term high-quality bonds and bond funds, there is a positive side to higher interest rates. Higher interest rates mean the bond returns you expect to earn are higher now than they were. For investors with a long-term horizon, this is a plus.

Investors must also keep their total portfolio in perspective. While bond returns are flat to slightly negative for the year, the global equity market was up 5.3 percent through June 11 (as measured by the MSCI World Index). Because one of the key concepts behind diversification is having investments that have low correlations to others, this again shows the benefits of having a well-devised approach to building diversified portfolios.

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