Are Bond Yields About to Rise?

Key Points

  • The era of very low and falling interest rates may be coming to an end, which could mean rising bond yields.
  • The shift to higher yields is likely to be slow, in our view, but markets don’t appear to be prepared for the change.
  • We suggest investors prepare for a potential rise in bond yields by trimming exposure to bonds with either long durations or high credit risk.

Is the market ready for higher bond yields? After years of extremely low yields at home and a surge in negative-yielding debt in Europe and Japan, you might think the market would seize on any sign that conditions may be changing. But that doesn’t appear to be happening.

The forces that pushed yields lower—low and falling inflation, and very easy monetary policies by major central banks—appear to be abating. While we don’t think this this means yields will snap sharply higher, these trends should lead to a slow increase over time.

Here, we’ll take a closer look at inflation and monetary trends and discuss some ways investors can prepare for the potential return of higher bond yields.

Inflation expectations

Inflation expectations are one of the main forces driving intermediate and long-term bond yields. In short, inflation eats away at the value of investment returns, so bond investors generally require higher bond yields (i.e., lower bond prices) as compensation if they think prices will rise over the long term.

So where do things stand now? Inflation expectations haven’t moved significantly higher in the past year. Market-based measures of inflation expectations, such as the difference between Treasury Inflation Protection Securities (TIPS) and traditional Treasuries, indicate only a slight increase in inflation expectations over the past year—and those expected inflation rates are below the Federal Reserve’s 2% target level. Consumers’ inflation expectations have actually softened over the past year. For example, the University of Michigan’s inflation expectations survey shows that consumers have lower inflation expectations for the coming year than they did last year, though those expectations are still above the 2% target level.

Inflation expectations haven’t changed much in a year

Source: Bloomberg. Readings for each category are as of 8/30/2016 and 8/30/2015. The breakeven inflation rate is a measure of inflation expectations based on the difference in yields between TIPS and regular Treasuries of comparable maturities. The five-yea, five-year forward breakeven rate is a measure of inflation expectations over the five-year period that begins five years from today.

Inflation is edging higher

How do those expectations stack up against actual inflation? There are many ways to measure price changes, but by most measures the trend is moving up.

The Fed’s preferred measure is the deflator for personal consumption expenditures excluding food and energy (core PCE), though Fed Chair Janet Yellen has said the bank watches many different indicators. Below we’ve compiled a chart of the indicators cited by the various members of the Federal Open Market Committee over the past two years. These different measures reflect different methodologies, but all show that inflation is higher today than a year ago. Several are now above the Fed’s 2% inflation target.

Inflation indicators have edged up over the past year

Source: Bloomberg. Readings for each category are as of 8/30/2016 and 8/30/2015.

Inflation is likely to drift higher now that oil prices and the dollar have stabilized. Although we don’t expect a significant rise in oil prices since supply is still high relative to demand, prices do appear to have settled into a range of about $45 to $50 per barrel after having dropped from more than $100 per barrel over the past two years. The drag on overall inflation from falling oil prices appears to be abating.

Similarly, the dollar has stabilized this year after rising 20% from mid-2014, which should also lessen downward pressure on inflation. When the dollar rises, it tends to slow growth by making U.S. exports less competitive and hold down import prices, reducing inflation pressures. With a more stable dollar, the dampening effect on inflation should ease.

Oil prices and the U.S. dollar have stabilized

Note: U.S. Dollar Index (USDX) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies. Source: Bloomberg. U.S. Dollar Spot Index (USDX) and Crude Oil Prices: West Texas Intermediate - Cushing, Oklahoma, Dollars per Barrel, Daily data as of 9/30/16. Past performance is no guarantee of future results.

Central Banks shift tactics

Meanwhile, foreign central banks appear to be shifting away from deeply negative interest rates, which could also help drive bond yields higher.

At its most recent meeting, the European Central Bank kept its target interest rate intact, contrary to expectations for a rate cut. Similarly, the Bank of Japan reviewed its policies recently and decided to adopt a policy that would target positive long-term interest rates. Both central banks have acknowledged that because low-to-negative interest rates squeeze banks’ profits from lending, such loose policy settings were actually making it difficult to push money into the economy. Moreover, very low to negative bond yields make it difficult for pension funds, insurance companies and other long-term investors to earn enough income to cover their obligations.

With nearly half of U.S. Treasuries held by foreign investors and the correlation among major international bond markets high, moves in one market can influence others. While still very low, bond yields in Japan and Germany have moved up from the most negative yields recently.

International bond yields have been rising modestly

Source: Bloomberg. Ten-year bond yields, U.S. (USGG10YR), Germany (GTDEM10YR) and Japan (GTJPY10YR). Data as of 10/4/16.

There are even some signs that after years of cutting interest rates and expanding bond buying programs, the era of expansive central bank policy may be reaching its limits. In recent months, many voices—including the International Monetary Fund and the Organization for Economic Coordination and Development—have pointed out that monetary policy can do only so much to boost economic growth and have called for governments to adopt more aggressive fiscal policy measures.

Pricing risk

Here again it’s not clear that the market is prepared for changing conditions. In fact, it appears investors may have become complacent about the risk of higher rates and are willing to take more credit risk in a quest for higher yields.

When interest rates rise, the prices of existing bonds tend to fall. In general, the prices of longer-maturity bonds tend to be more sensitive to rate changes than those of shorter-maturity bonds (you can measure a bond’s interest rate sensitivity by calculating its duration—the longer the duration, the more sensitive it will be to rate changes). But not all short-term bonds are equal.

Lower-credit-quality, higher-risk bonds in particular could see more price volatility in a rising rate environment. This is partly because higher-risk bonds may lose their appeal if comparable lower-risk bonds, such as Treasuries, start to offer higher yields. But lower-credit-quality bond valuations also appear to be quite high now, as yield-seeking investors have pushed prices up. That could mean they have further to fall if rates rise.

The yield spread, or credit spread, is the amount of yield potentially riskier corporate bonds offer above comparable Treasuries to compensate for the increased risk. The size of the spread is a measure of how much extra compensation investors require to invest in a potentially more risky bond. Normally, that means the higher the risk, the wider the spread. Today, the spread between high-yield bonds and Treasuries is below the long-term average, even though the underlying fundamental trends in the high-yield market are deteriorating.

High-yield spreads are now below the 20-year average

Note: Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan. Source: Barclays, monthly data as of 9/30/16.

In other words, there is very little risk premium in the market to compensate investors, even though defaults are rising and more bonds are being downgraded than upgraded.

As we saw during the taper tantrum of 2013, high-yield bonds can be much more volatile than Treasuries when investors grow more risk averse. From May 9, 2013 through June 25, 2013, the average yield-to-worst of the Barclays U.S. Corporate High-Yield Bond Index rose more than two percentage points, from 4.95% to 6.97%. The largest trough-to-peak move for the 5-year Treasury in 2013 was only 1.2%.

A sharp rise is unlikely, but there is room for yields to move up

To be clear, while we expect some increase in bond yields over the next few months, we aren’t expecting a sharp rise or a return to yield levels seen a decade ago. Growth and inflation remain low globally and we expect the Fed to move slowly.

However, the trends appear to be higher and the markets don’t appear to be prepared for higher yields. Even a rise in 10-year Treasury yields to 2%, a level not seen since beginning of the year, could mean prices falling by as much as 3% to 4%.

So what should investors do? We suggest:

  • Reduce the average duration of your fixed-income holdings. Again, short-term bonds tend to be less sensitive to rises in interest rates than long-term bonds, and we see less reward for investing in longer-term bonds today.
     
  • Check your risk tolerance. High-yield corporate bonds have generated strong total returns this year thanks to rising prices, but are looking relatively expensive now that yields have fallen. Investment grade corporate bonds appear fairly valued today, while high-yield corporate bonds appear modestly overvalued and may be prone to more significant price declines.
     
  • Review your fixed income portfolio. Almost all types of fixed income investments have posted positive returns in 2016, with long-term bonds and high-yield corporate bonds posting some of the largest gains. Make sure that your current allocation is still in line with your long-term goals. If price appreciation has pushed your fixed income holdings beyond your strategic allocation, it may be time to re-balance your portfolio.
     
  • Consider an allocation to TIPS. These securities tend to outperform traditional Treasury bonds when inflation is rising. You could also consider investment grade floating rate notes, which tend to outperform when short-term interest rates are rising.

Next Steps

Talk to Us

To discuss how this article might affect your investment decisions:

-          Call Schwab anytime at 877-338-0192.
-          Talk to a Schwab Financial Consultant at your local branch.

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