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Longer-term interest rates are on the rise. We take a closer look at the reasons why and how savvy investors can better prepare their portfolios for what's in store.
Unlike short-term rates, which are mostly driven by the U.S. Federal Reserve’s (Fed's) monetary policy, the yields on longer-term securities are in large part a reflection of market forces—namely, supply and demand. Yields rise as prices fall, of course, and an increase in yields can reflect a number of factors on both sides of that supply-and-demand dynamic. Here are four reasons why interest rates have been rising in 2021.
Source: United States Department of the Treasury, as of March 9, 2021. Past performance is not indicative of future results.
One reason yields on U.S. Treasury debt have moved higher is because there’s just so much of it. In the absence of new buyers, increased supply often leads investors to demand higher levels of compensation to absorb the excess issuance—and that translates to higher yields. Too much debt can also raise questions about borrowers’ ability to repay it.
Source: Federal Reserve Bank of St. Louis, as of March 9, 2021.
Another factor driving yields is the more optimistic outlook for the economy. A strong economy has historically been tied to higher yields on long-term debt, in part because investors tend to gravitate to riskier assets—such as stocks and high-yield bonds—that have tended to outperform when the economy is heating up. Less demand for such defensive asset classes means they need to offer higher yields to attract buyers.
Source: Bureau of Economic Analysis, as of March 12, 2021.
Another factor pushing rates higher today is the outlook for inflation. Bond investors often make buying decisions based on a security’s “real” interest rate, which reflects the income earned after accounting for the erosive effects of inflation. The higher the rate of inflation, the higher the level of income investors demand. While the rate of inflation today remains fairly subdued—still below the Fed’s stated 2% target—market watchers believe there are reasons to expect it may soon turn higher—maybe significantly so.
Source: Federal Reserve Bank of St. Louis, as of March 9, 2021.
About one-third of U.S. Treasury debt is held by foreign investors, including both foreign governments and institutions. Naturally, the U.S. government is both borrowing and repaying foreign creditors with U.S. dollars. When the dollar weakens, that means it’s worth less and less of any individual unit of a foreign currency—a trend that makes U.S. debt less appealing to foreign investors. One way those investors can respond is by demanding higher yields to compensate for the currency risk associated with dollar-denominated debt.
Source: Yahoo Finance, as of March 9, 2021.
While no one can predict the future, that doesn’t mean investors worried about rising rates can’t take action today. Here are three ways to navigate an uncertain interest-rate environment.
Not all segments of the fixed-income market are equally sensitive to changes in interest rates; high-yield bonds and securitized debt, for example, can often be more correlated with the macroeconomic backdrop than with the direction of interest rates. Investors may want to consider taking steps to ensure their portfolios offer exposure to a range of market segments in order to diversify away from a single source of risk, like duration.
Just like the dynamic with individual segments of the bond market, not all regions are experiencing the same macroeconomic conditions as the United States. For example, emerging markets, Asian, and Latin American economies all offer ways to diversify a bond portfolio away from U.S. market risks, while also providing an opportunity to pursue additional incremental income.
One last consideration is to introduce tactical positions into a portfolio. Floating-rate notes, as the name suggests, offer variable interest payments that reset higher when interest rates rise. Certain segments of the stock market may also be worth a look. The banking sector, for example, has historically outperformed when there are relatively wide spreads between short- and long-term rates.
This commentary is for informational purposes only and is not meant to be construed as a recommendation or advice. Before making any investment decisions you should consult with your financial professional.
Diversification does not guarantee a profit or eliminate the risk of a loss.
Fixed-income investments are subject to interest-rate and credit risk; their value will normally decline as interest rates rise or if an issuer is unable or unwilling to make principal or interest payments. Investments in higher-yielding, lower-rated securities include a higher risk of default. Foreign investing, especially in emerging markets, has additional risks, such as currency and market volatility and political and social instability. Stocks and other equities have generally outperformed other asset classes over the long term, but may fluctuate more dramatically over the short term. A portfolio concentrated in one sector or that holds a limited number of securities may fluctuate more than a diversified portfolio. Liquidity—the extent to which a security may be sold or a derivative position closed without negatively affecting its market value, if at all—may be impaired by reduced trading volume, heightened volatility, rising interest rates, and other market conditions. The use of hedging and derivatives could produce disproportionate gains or losses and may increase costs. Fund distributions generally depend on income from underlying investments, and may vary or cease altogether in the future. Please see each fund’s prospectus for additional risks.
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