Longer-term US interest rates may have finally given in to the upward pressure from short-term interest rates. This month the benchmark 10-year Treasury bond yield moved through its long-term trading range to levels that have not been seen since 2011.
Interest rates are now officially in a long-term upward trend. This may have implications on investment strategies as the bond market responds to the rising interest rates. Typically, longer-term bonds are more sensitive to changes in interest rates. When interest rates rise bond prices tend to decline. For example, the 20-year Treasury bond has declined 3.72% so far in October and is down 9.43% for the year. However, shorter-term bonds are often far more resilient when interest rates rise. Short-term Treasury bonds are down just 0.05% in October and have increased in value by 0.11% for the year. In other words, not all bonds respond to an increase in interest rates in the same way.
One of the most commonly used bond benchmarks, the Barclay’s US Aggregate bond index, is down just 0.88% in October and is down just 2.62% for the year. Meanwhile, many segments of the bond market have actually increased in value despite the increase in interest rates. For example, floating rate bonds, which pay a variable interest rate based on an interest rate index, have increased in value by 0.09% in October and 1.96% for the year. High-yield bonds, sometimes called junk bonds due to the borrower’s low credit rating, have also performed better than the broad market. High-yield bonds declined by 1.05% in October but have still appreciated 1.41% for the year.
There are several lessons that can be learned from the recent breakout in interest rates. First, interest rates have increased by roughly one-third from 2.40% at the beginning of the year to 3.23% today, yet many areas of the bond market have declined in value very little. This shows the lower risk nature (lower price volatility) that bonds typically exhibit. Therefore, investors may want to think twice before selling bonds to purchase riskier assets, such as stocks, which have a tendency to exhibit much higher price volatility.
Second, diversification is an important part of any risk management strategy. A bond portfolio that is dedicated to long-term bonds is likely to have reported larger losses this year. However, a portfolio that is diversified so that it includes short-term and intermediate term bonds, as well as some high-yields and/or floating rate bonds, will be far more likely to have weathered the recent interest rate storm with little or no decline in value.
Third, rising interest rates can make the long-term rate of return on bonds more attractive. Bonds that return interest and principle payments to investors fairly quickly allow for the money to be reinvested at the new higher interest rates. This can increase the interest rates that investors can expect to earn leading to higher returns over the long-term. In other words, short-term pain can lead to greater long-term gains. However, only those investors that focus on their long-term goals are likely to reap the benefit from higher interest rates.