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As investors digest another 0.75 percentage point increase in the Federal Reserve’s interest rate, government bonds could signal distress in the markets.
Ahead of news from the Fed, the policy-sensitive 2-year Treasury yield rose to 4.006% on Wednesday, the highest level since October 2007, while the benchmark 10-year Treasury reached 3.561% after hitting an 11-year high this week.
When short-term government bonds have higher yields than long-term bonds, known as a yield curve inversion, this is seen as a warning sign for a future recession. And the closely watched spread between 2-year and 10-year Treasuries continues to be reversed.
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“Higher bond yields are bad news for the stock market and its investors,” said certified financial planner Paul Winter, owner of Five Seasons Financial Planning in Salt Lake City.
Higher bond yields create more competition for funds that might otherwise go to the stock market, Winter said, and with higher Treasury yields used in calculations to value stocks, analysts could reduce expected future cash flows.
What’s more, it may be less attractive for companies to issue stock buyback bonds so profitable companies can return money to shareholders, Winter said.
How will the Fed rate hike affect bond yields?
Market interest rates and bond prices are usually move in opposite directions, which means that higher rates cause bonds to fall in value. There is also an inverse relationship between the price of a bond and the yield, which rises as the value of the bond falls.
The Fed’s rate hikes helped raise bond yields to some extent, Winter said, with the impact varying along the Treasury yield curve.
“The further you move down the yield curve and the more your credit quality deteriorates, the less the Fed rate hikes affect interest rates,” he said.
That’s the main reason for the inverted yield curve this year, he says, with 2-year yields rising more sharply than 10- or 30-year yields.
This is a good time to re-evaluate your portfolio diversification to see if changes are needed, such as asset reallocation in line with your risk tolerance, said John Ulin, CFP and CEO of Ulin & Co. Wealth Management in Boca Raton, Florida.
For bonds, consultants monitor so-called duration, measuring the sensitivity of bonds to changes in interest rates. Expressed in years, the duration factor in the coupon, the time to maturity and the yield paid over the term.
While clients welcome higher bond yields, Ulin suggests keeping duration short and minimizing exposure to long-term bonds as rates rise. “Duration risk could take you out of savings over the next year, regardless of sector or credit quality,” he said.
Winter proposes to shift the distribution of stocks towards “value and quality”, typically trading at a price lower than the asset’s worth, rather than growth stocks that can be expected to generate above average returns. Often, value investors look for undervalued companies that are expected to rise in value over time.
“Above all, investors must remain disciplined and patient, as always, especially if they believe rates will continue to rise,” he added.