On Investments

The good and mostly bad of rising interest rates

While bond prices are falling, higher interest payments cushion the blow

Jan 31, 2018 @ 1:00 pm

By John Waggoner

When a racoon leaps at you from the back seat, causing you to run your new car into a bridge abutment, people will always point out how lucky you are. Hey, the bridge didn't collapse on you! Good thing you had insurance! Thank goodness the raccoon didn't have rabies!

Today's column is about lucky bond investors.

Bond prices fall when yields rise, and vice-versa, and, unfortunately for bond investors, yields have been rising. The great bond bull market ended in July 2016, when the yield on the bellwether 10-year Treasury note hit an all-time low of 1.37%. As of Wednesday, the 10-year T-note yielded 2.74%.

A bear market in bonds is like being nibbled to death by ducks: It's usually a slow, wearisome process. The Vanguard Total Bond Market Index fund (VBMFX) has fallen 1.2% this year, according to Morningstar Inc. Since July 2016, however, reinvested interest has softened the blow: It's down just 0.13%.

Naturally, the type of fund you're in makes a difference. Vanguard Extended Duration Treasury Index (VEDTX), for example, has declined 10.3% since July 2016, and Pimco Extended Duration (PEDIX) had a 0.3% loss. At the other end of the spectrum are AlphaCentric Income Opportunities I (IOFIX), a multiasset bond fund, up 20% since July 2016, followed by Fidelity Capital & Income (FAGIX), a high-yield fund, up 19.6%.

What's causing the bond market to swerve off the highway is the same thing that's sending the stock market speeding down the road: good economic news. The bond market is only happy when it rains. A rapidly rising economy often means inflation is heading our way, followed by rate hikes from the Federal Reserve. And, at least at the moment, forecasters are looking for higher rates.

"I think there is more of a climb in store unless we see a sell-off in equities or evidence that the economy is losing momentum," said John Lonski, team managing director of the economics group at Moody's Analytics. "But right now, the equity market wants to go higher, and that will push bond yields higher."

Another force behind rising rates: increased supply of Treasury securities. The Fed is winding down its quantitative easing program, meaning it will be selling Treasuries in the open market. All other things equal, the Fed's actions will push rates up. Similarly, the additional $1.5 trillion added to the federal debt by the recent tax cuts will prompt the government to sell more debt.

Finally, there's the fear of rising inflation — which, it should be noted, has been feared for nearly a decade but has not materialized. Two possible sources of inflation would be the decline of the dollar on the international currency markets, as well as an increase in commodity prices. The falling dollar makes U.S. goods cheaper abroad, but also increases the cost of imports in the U.S. (New tariffs on imports will have the same effect, as it has had on Canadian lumber.)

Commodity prices, too, have been rising. Gold, the traditional barometer of inflation expectations, has gained about 12%. The S&P GSCI All Metals Index has gained 17.4% the past 12 months.

"That favors an advance in yields," Mr. Lonski said.

Inflation or no, the Federal Reserve is likely to raise short-term interest rates at least another two times this year, in part so it can simply return rates to normal from abnormally low levels. While the Fed doesn't have direct control over long-term bonds, it's unlikely that short-term yields would rise above long-term yields in a growing economy.

At least so far, the best places for bond investors to be have been high-yield bonds, whose interest payments have done much to shield investors from damage. Vanguard High Yield Corporate (VWEHX), for example, has eked out a 0.18% gain in 2018. Those who went abroad for higher yields were also rewarded: Emerging-markets local currency bond funds have gained 3.4% this year.

The problem with higher rates is that they may ultimately hit the stock market harder than the bond market. Higher interest rates slow the economy and the stock market.

One example: Mortgage applications fell 2.6% from a week earlier, according to the Mortgage Bankers' Association. And the average 30-year fixed mortgage rate has risen to 4.41%, its highest level since March 2017. Real estate funds, which invest mainly in commercial real estate, have tumbled an average 4.9%, making them the worst-performing Morningstar sector funds this year.

You can't read too much into housing data in the dead of winter, and no one is really sure how the new tax law will affect home sales in states with high income and property taxes, such as New York and California.

But at least for now, bond investors should feel somewhat lucky: Their funds have performed the way they are supposed to. And should the stock market tumble, they will feel particularly lucky.

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