Don’t Let Rising Interest Rate Worries Get You Down

This report was prepared by my firm LPL Financial.

Bond investors have always worried about the impact of rising interest rates on their portfolios and rightly so. So, higher yields in the market translate to lower prices for existing holdings and investor worries about rising interest rates. Their worries have increased over the second quarter of 2009. As we
approach the midpoint of the year, many investors are no doubt concerned over the rise in the benchmark 10-year Treasury note yield from 2.2% to 3.5% (through June 29). Worries over higher yields (lower prices) and potential losses may resurface as investors look to the second half of 2009
and beyond.

  • While Treasury yields have increased, yields in other key segments of the bond market are actually lower now than at the start of 2009.
  • When considering the impact of rising interest rates, investors need to assess the time period over which that increase occurs.
  • We believe there is enough of a buffer against higher interest rates in non-government bonds for the broad bond market to produce mid-single digit returns for the full year.

Despite the rise in 10-year Treasury yield, the average corporate bond yield is actually lower now than at the start of the year. The yield on the Barclays Capital Corporate Index stood at 6.0% as of June 25, down from 7.5% at the end of 2008. Corporate bonds benefited from improving liquidity and investors taking advantage of cheap valuations, while Treasuries faced high valuations with massive new issuance.

Municipal Bonds Lower

Similarly, Municipal bond yields are lower in 2009. The average yield on 10-year AAA-rated Municipal bonds declined while the 10-year Treasury yield increased. Like Corporate bonds, Municipals benefited from better liquidity and investors taking advantage of cheap valuations.

While the performance above seems counter intuitive, it highlights the importance of sector allocation in the bond market and the fact that higher Treasury yields (lower Treasury prices) don’t necessarily translate into higher yields (lower prices) across the entire bond market.

The most striking yield disparity is in the high yield market, where the average yield declined from 21.0% to 12.7%. Historically, High Yield bonds, more sensitive to changes in the underlying economy, have often diverted from higher quality bonds and been able to withstand higher Treasury yields.   We believe the yield disparity will slow but not completely disappear over the second half of 2009, as we discuss later.

Timing

When considering the impact of rising interest rates on your bond portfolio,timing plays a crucial role. Over short periods of time, higher interest rates translate into lower bond prices—interest income is unable to soften the blow in terms of total return. Over longer periods of time, interest income is the main driver of bond performance and can be a powerful force. The impact of higher interest rates can be offset by interest income. This is one reason why the bond market still managed positive total returns in the late 1970s and early 1980s despite a rise to double-digit interest rates.

As an example, using the current 5-year Treasury note, a 0.50% rise in 5-year interest rates would result in a 4.4% loss from June 29 to September 30, 2009, a 3-month holding period. However, if holding for one-year, the bond actually would produce a positive total return of 2.3%, as interest income would offset the price decline associated with higher interest rates.

When the gap between shorter-term and longer-term yields is relatively wide, the yield curve is considered “steep” and it also provides downside protection. Yields are generally lower for short-term maturities, reflecting lower interest rate risk. However, as a bond moves closer to maturity, it benefits from “rolling down” into a lower-yielding segment, which provides price support as a bond approaches maturity, even if interest rates rise. Interest income is a potentially greater buffer for non-Treasury securities when yields are higher. According to Bloomberg, the average A-rated, 5-year maturity Corporate bond yield was 2.7% above Treasuries (as of June 29,2009), a signifi cant income advantage. For an investor looking to guard against higher market interest rates that might result from an improving economy, the added income might be more than sufficient to compensate for the credit quality differential, since Treasuries are AAA-rated. This is our bias and one reason we continue to favor Corporate bonds. The income
advantage between A-rated Corporate bonds and Treasuries has declined but still remains above the prior peak in 2002.

In the municipal market, long-term Municipal bond yields are still above comparable Treasury yields, which suggest the divergence witnessed so far this year may continue. The average AAA-rated 30-year Municipal bond yield of 5.16% (as of June 29) is 120% of the 4.29% yield on the current 30-year Treasury bond. Prior to the start of the credit crunch in July 2007, this Municipal/Treasury yield ratio was 92%. If this relationship were to return to pre-crisis levels, the 30-year Treasury yield could hypothetically rise to 5.61% (taking the 5.16% Municipal bond yield and divide by 0.92), while Municipal bond yields and prices remain unchanged. While we don’t believe it play out exactly this way, it shows how Municipal bonds could withstand higher Treasury yields.

Risks of Relying on Interest Income

One of the risks to relying on interest income is that absolute yields, on balance, remain low by historical comparison, definitely true for government bonds but less so for Corporate bonds. The beneficial impact of interest income is therefore reduced, but not enough to offset our expectation of mid-single digit returns for the bond market in 2009.

Gradual Improvement over the Remainder of Year

The divergence between the direction of Treasury yields versus Corporate and Municipal bonds over the first half of 2009 has been impressive. We expect this trend to persist but also anticipate it will be more gradual over the second half of 2009. The yield disparity between Treasuries and non-Treasury sectors such as Municipal and Corporate bonds still remains wide and may offset the impact of higher Treasury yields.

Over a longer-term horizon we do expect higher interest rates/higher bond yields, but believe that outcome will require an acceleration of inflation and/or Federal Reserve interest rate hikes. We see neither as likely over the second half of 2009 or the beginning of 2010. Until then, upward pressure on interest rates will be offset by interest income. As a result, we remain focused on intermediate bonds that benefit from a steep yield curve and sector allocation where yield differentials are still wide. We believe it is too early to take a defensive posture in short-term bonds.

IMPORTANT DISCLOSURES

  • The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
  • Neither LPL Financial nor any of its affiliates make a market in the investment being discussed nor does LPL Financial or its affiliates or its officers have a financial interest in any securities of the issuer whose investment is being recommended neither LPL Financial nor its affiliates have managed or co-managed a public offering of any securities of the issuer in the past 12 months.
  • Government bonds and Treasury Bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
  • The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
  • Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
  • High Yield/Junk Bonds are not investment grade securities, involve substantial risks and generally should be part of the diversifi ed portfolio of sophisticated investors.
  • GNMA’s are guaranteed by the U.S. government as to the timely principal and interest, however this guarantee does not apply to the yield, nor does it protect against loss of principal if the bonds are sold prior to the payment of all underlying mortgages.
  • Muni Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and state and local taxes may apply.

Related Posts with Thumbnails

Get the Money Dominating Toolkit

Sign up for free below and get the following:

  • 6 Tools to Get Your Money Back on Track
  • The Ultimate Goal Achiever Workbook
  • 2 Free Chapters to my Best Selling Book
  • 21 Days to Destroy Your Bad Habits Worksheet

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>