There are still very few bargains out there for people buying bonds, and some areas of the bond market are more vulnerable to rising rates than others. This means it’s especially important to do your homework and choose your bonds wisely.
For instance, shorter maturity Treasuries, those with durations of two- to five-years, are likely to be more vulnerable to rising rates than their counterparts with longer durations. In addition, with most traditional areas of the bond market looking expensive investors should consider a flexible, go-anywhere approach. Finally, investors should give munis another look, if they haven’t already, as I explain below.
Market Realist – The graph above shows U.S. Treasuries with short-term maturities (SHY) and longer-term U.S. Treasuries (TLT). In general, as the federal funds rate increases, the yields of short-term maturities also increase while their prices fall. But the yield swings in longer maturities are much higher, so their prices fall much more than shorter-term bonds. This difference is due to their higher duration, which we can simplify as the longer average maturity of the bonds’ cash flows.
A hike in interest rates is likely to affect all instruments of the U.S. equity (SPY)(IVV) and bond markets (BND) spectrum. In the current environment, however, long-term U.S. Treasuries might not be as severely affected as usual. If rising rates subdue growth, then longer rates may not increase as much.
Plus, rising geopolitical tensions cause investors to revert to U.S. Treasuries and other safe haven assets like gold (GLD) and silver (SLV). Also, the slowdown in Europe (EZU) and Japan (EWJ) has affected bond yields in the areas, making them fall to historical lows. This has been one of the primary reasons why U.S. Treasuries have witnessed inflows, as they look like better investment prospects in comparison. This trend could extend to the future as well if other international markets (QWLD)(URTH) continue to struggle.
Given the uncertainty of which part of the yield curve will be worst hit, we actually believe raising cash or at least staying under two-year bond maturities is currently the most prudent approach.
Read on to the next part of this series to see how municipal bonds can bolster your fixed income portfolio.