This month we investigate how rising interest rates impact bond and stock returns and what it means for you and your portfolio.
The yield on the 10-year Treasury rose sharply in late February and early March, back to pre-pandemic levels of approximately 1.50%. This is an increase from 0.93% to start 2021 and its all-time low 0.52% in August. Most would think getting back to anything referred to as pre-pandemic would be a good thing, but rising interest rates causes bond prices to decline. In addition, as rates moved higher major stock indexes retreated from record highs. The tech-heavy NASDAQ saw the most dramatic decline, down almost 10% from its recent high on February 11th. This article investigates how rising interest rates impact bond and stock returns and what it means for you and your portfolio.
Why have rates risen? Two factors widely seen as pushing Treasury yields higher are expectations of a strong economy coming out of the pandemic and concerns of higher inflation. As vaccines rollout, many are hopeful businesses will be able to fully reopen, and more people can get back to work. Some believe pent up demand along with the additional $1.9 trillion stimulus bill will push an already improving economy to faster growth. Typically, interest rates rise when an economy’s growth prospects improve. The improving economy coupled with the stimulus bill has raised concerns about rising inflation. According to CPI data, inflation has been on the rise with food and energy seeing the biggest increase. Even though inflation has ticked up, it is still within the range set by the Fed. The Fed has stated it will allow inflation to go above its 2% mandate temporarily to not derail the economic recovery. The concern inflation may rise faster than anticipated likely aided the sharp move higher in the 10-year yield.
Why did bond prices fall when interest rates moved higher? Bond prices and interest rates are inversely related. As interest rates move higher, bond prices go lower. A simple example helps illustrate how it works. Treasury Bond A was issued with a 3% interest rate. A month later Treasury Bond B was issued, but interest rates have increased so it has a 4% interest rate. Bond A is the exact same as Bond B, but it has a lower interest rate. The only way an investor would by Bond A was if its price went down. Thus, Bond A’s price would fall to the point that it would yield, or have the same interest rate, as Bond B. While over the short term an increase in interest rates is a negative as bond prices will fall, over time the increase in interest rates is a positive.. The expected return for bonds will be higher making bonds a more attractive investment. In addition, with interest rates at higher levels it provides the potential for greater protection for the stock side of the portfolio. High quality bonds are seen as a safe haven asset. If the stock market were to fall significantly investors would likely flock to high quality bonds. The increase in demand would push prices higher and yields would go lower. A higher starting point would give rates fall and provide a greater hedge against stocks.
Why did equities pull back from all time highs at the same time rates moved sharply higher? Some of it has to do with the way equities are priced. When trying to figure out a stock’s price there are a couple things to consider. You need to forecast what you believe the company will earn in the future and what you are willing to pay for those future earnings. One input used is the risk-free rate. The risk-free rate is the rate of return you would expect to earn if you invested in the safest investment. Analysts use the US 10-year Treasury as the risk-free rate because Treasuries are believed to be one of the safest investments. As that rate goes up investors require higher returns from riskier assets. The result is a lower price they are willing to pay for a company’s future earnings. Another reason for the recent fall in equities is fear inflation will run faster than expected forcing the Fed to raise interest rates. This could negatively impact the economic recovery as the cost of borrowing would increase.
How does an increase in interest rates affect your personal finances? Higher interest rates affect you in two ways. On the positive side, it provides higher yields for savers. As we know checking and savings accounts are currently paying next to nothing so any additional boost in rates is helpful. On the negative side, it increases the cost of debt. Any variable interest rates such as credit cards will adjust higher resulting in higher interest costs. The cost of new debt such as mortgages to buy a new home or a car loan would also increase.
How does this impact how you should invest your portfolio? The simple answer is it should have very little if any impact on your overall investment strategy. As in most cases, diversification is key during times of volatility. A well-diversified portfolio can help minimize the effects of short-term market volatility. Being well diversified in your fixed income portfolio can also help minimize the effect of a raising rate environment as not all types of bonds react to a change in interest rates the same way. In addition, we recommend tilting the portfolio to be shorter term than the broad bond market. Short term bonds are not as negatively impacted by an increase in interest rates as long term bonds.
As we’ve seen there are many variables that effect both the bond and equity markets. Having a better understanding of how they are related can give some insight into market movements. The more you understand the market, the easier it is to ignore short term volatility. Having a well-diversified portfolio can give you the confidence to stay the course during times of volatility. Staying disciplined to your long-term financial plan will position your portfolio for success.