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Are Bond Fears Warranted in Light of Interest Rates Expectations?

After a sharp rebound the week before, stocks struggled early on to keep momentum. Wednesday’s release of the Fed minutes drove an end-of-day selloff and small uptick in bond yields, as fears resurfaced over faster-than-expected interest rate hikes. However, a strong rally on Friday allowed global stocks to end the week in positive territory. Domestic bonds were flat to slightly up.

Weekly Returns:

S&P 500: 2,744 (+0.4%)
FTSE All-World ex-US: (+0.2%)
US 10 Year Treasury Yield: 2.88% (+0.01%)
Gold: $1,329 (-1.4%)
EUR/USD: $1.229 (-0.9%)

Major Events:

  • Monday – Presidents’ Day in the United States.
  • Tuesday – Walmart fell short of expectations after misjudging its online inventory, negatively impacting online sales growth as it competes with rival Amazon.
  • Wednesday – According to the most recent Fed minutes, officials increased their growth and inflation expectations.
  • Friday – The United States unveiled new sanctions against North Korea, aimed primarily at shipping and trading companies.
  • Friday – General Mills announced it would buy Blue Buffalo, a natural pet food maker, for approximately $8 billion.

Our Take:

Based on the recent Fed minutes, officials now expect the economy to grow even faster over the coming year. They also believe inflation is more likely to return to their 2% target. The news sparked another small selloff Wednesday, based on fears of faster-than-expected interest rate hikes, which also caused a modest increase in bond yields. However, it’s the latter of the two events (i.e., bond yields) that seems to capture an increasing amount of the media’s attention. More and more headlines are painting a dour and extremely pessimistic outlook for bonds as interest rate expectations move higher. This of course stokes fears that bonds are toxic and should be avoided altogether.

But are these fears warranted? It really depends on the makeup of your bond portfolio. We all know bond prices are inversely correlated to interest rates, meaning one would expect prices to fall as interest rates rise. But this doesn’t always play out as many would expect. Just take a look at what transpired in the United States since the Fed began raising rates in late 2015. If you had owned a diversified mix of bonds, such as AGG (iShares Core US Aggregate Bond ETF), you would have made almost a 4% positive return over that period.

How is this possible? This is partly because market forces, like supply and demand, play a bigger role in determining intermediate and long-term rates than the Fed, which only focuses on short-term rates. But another reason is the fund’s makeup, which includes exposure to corporate bonds. These are less sensitive to interest rates and performed rather well over the last couple of years. Had the fund also included high-yield corporate bonds, its performance would have been even better.

But even as intermediate and long-term rates do begin to rise, as we’ve seen very recently, the impact can be mitigated with a shorter duration profile. As an example, the same diversified ETF mentioned above (AGG) has a modest duration of about 6, and it is only down about 1% over the last month. This is hardly worth losing sleep over when you consider stocks can move that amount in a single day. Moreover, investors often forget how valuable bonds can be during more severe downturns. Just look at 2002 and 2008, when the S&P was down ~22% and ~37%, respectively. During each of those years, intermediate-term Treasuries were up about 13%.

So despite what you hear, bonds still play an important role in well-diversified portfolios.

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