Hello bond yields, my old friend / I see you’re rising once again

I’ll admit that most investors may not see the recent backup in yields as anything to sing about. Rising market yields means falling prices for existing bonds. With the yield on the benchmark 10-year Treasury note flirting with 3% after starting the year off below 2.50%, 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.)

But while higher yields put pressure on the market value of existing bonds in a portfolio, they also present an opportunity to invest anew. How should investors evaluate these new higher yields?

For at least the last two decades, the return from investing in a bond was driven partly by the stream of coupon payments and partly by the fact that consistently falling market yields made the bond itself more valuable. Now we see a return to historical norms, where the vast majority of a bond’s return is determined by the yield at which it was purchased, and there is less opportunity for additional capital appreciation.

Going forward, investors should center their long-term return expectations on the yields they are getting on their bond investments today. They shouldn’t expect the same level of capital appreciation that was available during the prior decades due to falling interest rates.

A cyclical rebound

Will rates continue rising unabated? We don’t think so. Our view is that the U.S. economy is enjoying a cyclical rebound after a long period that began with the 2008 financial crisis, in which secular forces—globalization, demographics, and technology—restrained growth. Those forces are still very much in play, and we believe they will ultimately limit the amount of central bank tightening. However, this cyclical uplift is giving central banks around the globe an opportunity to remove monetary-policy accommodation and raise rates.

Importantly, other major economies are also experiencing a cyclical uplift, reinforcing one another to some degree. The risk to bond returns is that the Federal Reserve may see that there’s enough economic activity, or signs of inflation, to embolden it to raise interest rates faster and higher than anticipated.

We’re watching this situation closely but, from a portfolio strategy standpoint, see no reason to change our approach.

We’re maintaining an overweight to credit in our internally managed funds, with the expectation that supportive economic conditions can continue to cause credit to outperform. At the same time, we have a relatively neutral interest rate risk stance.

We’re not forecasting dramatic underperformance by bonds relative to their long-term average results. We stand by our economic and market outlook for 2018, in which we forecast global fixed income returns in the range of 2%–3% for the next decade. And while such returns may seem underwhelming to some, we believe bonds remain attractive for their ability to diversify equity market risk.

Notes:

  • 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.
  • Diversification does not ensure a profit or protect against a loss.
  • All investing is subject to risk, including possible loss of principal.