While Russ doesn’t foresee a bond market meltdown, he does expect that rates will rise in coming years and he offers three suggestions for positioning equity portfolios in preparation.
Even if the Federal Reserve (Fed) begins tapering its asset purchases next month, I don’t believe a bond market meltdown is imminent thanks to the many factors helping to keep a lid on interest rates.
Still, as I write in my new Market Perspectives piece, “Investing in a Rising Rate Environment”, the yield on the 10-year Treasury is up about 100 basis points from all-time low and yields are likely to continue to moderately rise over the next one to two years.
This begs the question: How should investors adjust their portfolios for slowly rising rates? Probably the simplest prescription may be to shift the portfolio mix toward stocks, which historically have improved portfolio performance during periods of rising rates, as my colleague Daniel Morillo recently pointed out, while considering the increased risk of such a change.
Market Realist – As the graph above suggests, equity markets (SPY)(IVV) seem to perform well in inflationary periods. But the opposite is not necessarily true. Equity markets may or may not perform well when inflation is low, depending on market dynamics. Inflation is a good proxy for interest rates. The Fed increases interest rates when inflation is high in order to rein inflation in.
Both Treasuries (TLT)(IEF) and corporate bonds (LQD) underperform when interest rates rise. As a reminder, bond prices and yields are inversely related. If interest rates increase, investors would rather buy the new bonds, which are providing a better coupon rate, than buy the older bond providing a lower coupon rate. The old bonds drop in price as a result. This trend explains the inverse relationship between yields and prices.