Bond investors are in for a rude awakening when it is time to look at November account statements.
As the ten-year treasury yield jumped from 1.83% to 2.37%, the Lehman Brothers Aggregate Total Return ETF (AGG) was down 2.68%. The 7-10 year Treasury ETF (IEI) was down 4.23% for the month and the the Long Term Treasury ETF (TLT) fell by 8.39%. Both of the Municipal Bond ETFs (MUB) and (TFI) lost over 4.25% for the month as well.
While the absolute level of yields did not break into new territory, what was alarming to investors was how quickly they jumped.
Which begs the question(s) why did yields rise in the first place and what should investors do in response?
Why Did Yields Jump?
For starters, even by post 2008 crisis standards, yields were pretty low to begin with and were perhaps set to rise no matter what. In September Bloomberg noted that Bond Guru Jeffrey Gundlach stated that “interest rates have bottomed. They may not rise in the near term as I’ve talked about for years . But I think it’s the beginning of something and you’re supposed to be defensive.” The article went on to say that Gundlach cited a low in yields in July (ten-year below 1.4%) that did not hold and that he predicted the U.S. ten-year bond could rise to more than 2% by year end.
Next, there is no question that the presidential election results provided the catalyst for the swiftness of the rate spike. Indeed, ten-year yield jumped from 1.86% to 2.07% the day after Mr. Trump’s upset victory, and clearing Gundlach’s hurdle nearly two months ahead of schedule.
Speaking on CNBC the week after the election, Art Cashin noted that the “rapidity” in the yield spike was as noteworthy as the actual increase and speculated that perhaps Mr. Trump’s infrastructure spending and tax cut plans had brought a return of the bond vigilantes.
Another likely contributor to the rise in yields is good old fashioned rotation. Money has been flowing out of bonds and into stocks which have responded well to the election. Financial stocks have lead the way, buoyed by an increase in interest rates along with the anticipation of improvement on the regulatory front. In addition is the prospect of a drop in corporate taxes, which is clearly benefitting a number of equity sectors. Lipper Alpha noted that “for the month of November investors redeemed a net $17.9 billion from taxable bond mutual funds and ETFs … This most recent five-week stretch of net redemptions was the longest since the week ended January 20, 2016, a hangover from the 25-basis-point increase in the Fed Funds rate on December 17, 2015.”
It is important to note that as quickly as rates have moved we are not at levels that have not been seen, even eight years into “emergency extraordinary” fed policy and rates. The ten-year yield was at 3.0% at the beginning of 2014 and at levels similar to the current rate of 2.4% in July of 2015.
That said investors should be prepared (as always) for at least an attempted return to policy normalization and the potential side effects. Last December’s 25 basis point increase by the Fed strengthened the U.S. Dollar and seemed to create havoc for Chinese monetary policy and related outflows resulting in a nasty global market sell off to start 2016. Given the Dollar’s strength relative to the Yuan throughout the year hopefully this time around an (an almost certain December) increase by the Fed will be more easily absorbed by China and world markets.
Another potential pitfall for fixed income investors is the nature of global trade relations. Whatever one does or doesn’t think about Mr. Trump and the prospects for success in re-negotiating trade deals there is no question that his negotiating style is likely to ruffle some feathers and create turbulence even in the best case scenarios. Investors should not be surprised if the topic of Chinese purchases of U.S. treasuries makes its way into the news cycle in the near future.
Investors who have an existing allocation plan that is not too heavily weighted to longer maturities probably don’t need to do anything other than sit back and “re-balance” if the opportunity arises. Those who do have significant exposure to the longer maturities and don’t have a plan to deal with increasing rates may want to consider moving such exposure to bonds or ETFs that invest in short term maturities.
ETF’s that may accomplish such an objective include iShares 1-3 Yr Credit Bond ETF (CSJ) on the taxable side. For tax-free municipal investors the SPDR Nuveen Bloomberg Barclays Short Term Municipal Bond ETF (SHM) has an average maturity of roughly three years. iShares also offers exposure to short term treasuries via the 1-3 year Treasury Bond ETF (SHY) and the 3-7 Year Treasury Bond ETF (IEI).
As always. Investors should do proper due diligence and speak to their financial advisor before making investment decisions.
It should also be noted that equity investors should not take their eye off the interest rate ball either. Thirty-four years into a raging bull market for bonds, it is easy to forget just how out of the norm current fed (and global central banking) policy is. A rising interest rate environment is traditionally bad for stocks, but in the current scenario there is the added element of the financial system’s ability to withstand significant rate increases and the potential ripple effects of derivative and counter-party exposure. While this should not be taken as an outright doom and gloom prediction, it should be not be forgotten that the economy is still in unchartered waters.
DISCLAIMER: Nothing in this article should be construed as a personal recommendation or investment advice. Nor should anything in this article be construed as an offer, or a solicitation of an offer, to sell or buy any particular investment security. Investors should conduct their own due diligence and seek the advice of a financial and/or investment professional before making any investment decisions.