Why yields for intermediate-duration bonds should increase

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Rates at the “belly” of the yield curve will rise more dramatically than long-term rates: This might seem counter intuitive since shorter-term rates are generally less sensitive to rising rates (lower duration = lower rate sensitivity), but we expect the yield curve to flatten and for rates at the belly of the curve (3 to 7 year segment) to rise more dramatically, and remain more volatile, than long-term rates—bad news for shorter-duration assets, and an argument for maintaining flexibility in bond duration positioning.

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Market Realist – As you can see in the chart above, the yield curve rates between the three-year and seven-year Treasuries have a slight bump compared to the rest of the Treasuries. This reflects the susceptibility of short and intermediate Treasury bonds to an early rate hike. So they have higher yields than usual.

This phenomenon is also visible in investment-grade corporate bonds (LQD) and high yield corporate bonds (JNK)(HYG) as well as other non-Treasury bonds. In contrast, longer-duration bonds, Treasury (TLT)(IEF) or otherwise, have already seen an increase in interest rates. Any further upward rate action in that area is likely to be less severe than in 2013.

The bottom line is that we think a traditional approach to fixed income investing will struggle. Investments that track or mirror broad market indices such as the Barclay’s U.S. Aggregate Bond Index (AGG) are overly concentrated in government-related debt (which will suffer if rates rise) and don’t have sufficient flexibility to adapt as market conditions change.

That’s one of the key reasons we would suggest looking at a more flexible approach to fixed income investing, known as unconstrained investing. Specifically, we would suggest you consider an adaptable, go-anywhere fund that seeks to capitalize on evolving market trends—one like BlackRock’s Strategic Income Opportunities Fund (or SIO).

There’s no magic bullet that can solve the bond conundrum of rate volatility and rapidly changing markets, but investing in a flexible, all-in-one fixed income portfolio that is not tethered to a benchmark should be a consideration.

Market Realist – Read our series Investing in fixed income: What motivates bond investors? to learn more about bond investing.

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