Making Sense of the Recent Spike in Interest Rates and How it Impacts Your Portfolio

After rising back above 3% in September, the 10-Year Treasury yield has now climbed to 3.20% in early October reaching the highest level since July of 2011.  This increase in yield is a result of multiple factors: strong recent US economic news; the agreement on a revised NAFTA accord which alleviated trade concerns in North America and made investors more optimistic about the US reaching deals with other nations; and the Fed’s continued desire to increase the Fed Funds rate to prevent the economy from overheating.  The Fed Funds rate is currently a range between 2% to 2.25% and the Fed projects to continue to raise its benchmark rate until reaching approximately 3.25% in 2020.

When interest rates rise existing bond prices fall because new bonds are issued with higher yields.  As a result, bonds, as measured by the Barclays Aggregate bond index, have fallen approximately 1.4% from September through early October.

This is a good time to revisit how bonds work, the purpose they serve in a portfolio, how they can be impacted by market forces and how your bond portfolio is positioned.

An increase in interest rates is a temporary negative for your portfolio.  The bonds held in your portfolio are now reinvesting the income and proceeds from maturing bonds in higher yielding bonds, so the yield on your allocation to bonds will rise thereby increasing the expected return moving forward.

While it’s disappointing to see negative performance from bonds they still serve a vital role in the portfolio.  First, bonds provide stability and capital preservation, counter balancing the much more volatile equity side of the portfolio.  While we’ve seen the broad bond market decline approximately 1.4% from September through early October the US stock market has fallen by 1.4% or more 11 times this year in just one day alone.  Second, the two asset classes have very low or negative correlation with each other meaning they tend to move in the opposite direction of each other.  As a result, it is likely there is an asset class rising at all times.  For example, this year while bonds are down 1.6%, US stocks have gained 10.6%.  Finally, holding a high quality fixed income allocation has shown to perform particularly well when stocks are at their worst.  Thus, when your portfolio needs bonds the most.  From the peak of the market in October 2007 until the bottom in early March 2009 the US stock market fell 50% cumulatively.  Over that same time high quality bonds, as measured by the Barclays Aggregate Bond Index, were up cumulatively 7%. We believe they will hold up well again the next time we see the stock market dive.

The action of the Fed increasing the Fed Funds rate is on the whole a positive as it signals that the economy is strong and growing and doesn’t need accommodative policy to support it.  These moves also primarily impact the very short end of the yield curve – bonds with maturities of roughly three years or less.  Intermediate and longer term interest rates are impacted by the Fed, but to much a lesser degree.  Future economic expectations and the expected rate of inflation are much stronger drivers on how longer term interest rates change.  If we see economic expectations start to cool we will likely see interest rates moderate or decline.  In addition, the Fed may reverse course or pause its interest rate increases if we saw a change in the health of the economy.

The recent gains in yield now make bonds a more appealing investment.  Investors may be willing to move from stock holdings to bonds for the more dependable and stable return expectations.  In addition, interest rates around much of the world remain very low and with the high credit quality and now higher yields available for US government bonds, they become more attract for foreign investors.  With greater demand it can drive up the price of bonds limiting future potential increases in interest rates.

Your portfolio is well positioned to handle an across the board increase in interest rates.  We target a shorter term average maturity in your fixed income allocation than the broad bond market.  Shorter term bonds are less impacted by interest rate changes than intermediate and long term bonds and thus makes it likely that the fixed income allocation would hold up better than the total bond market in a rising interest rate environment.  The allocation is also diversified among sectors and by geography.  Each sector and country has their own yield curves and have a variety of issues that impact them.  While rates might rise for US bonds, for example, interest rates could be falling in other parts of the world.  Currently, other developed market central banks in Europe and Japan are still maintaining very accommodative interest rate policies.

 We will continue to keep a close eye on your fixed income allocation and may consider recommending adjustments if we believe they will be in your best interest.  Regardless of the recent decline in the performance of fixed income, we strongly believe that maintaining a high quality fixed income allocation is an important part of well balanced portfolio.