Though I don’t expect a big selloff in bonds, causing rates to sharply climb back up, I do expect interest rates to rise modestly in the second half of 2015. Even a small rate rise puts bond holders at risk, and at current prices, I don’t think traditional taxable bonds, notably Treasuries, offer enough value to compensate investors for those risks.
Market Realist – Bonds could underperform as interest rates rise
The graph above shows the federal funds rate over the last 30 years. The federal funds rate is a mechanism through which the Fed regulates interest rates in the US. Meanwhile, actual rates depend upon the market mechanism. The rate has been stuck at ~ 0% for the last six years. The Fed’s current targeted rate is 0% to 0.25%.
The Fed has kept interest rates low to boost consumption and investment in the economy. This has helped keep Treasury (TLT)(IEF) yields low. It’s also helped the S&P 500 (SPY)(IVV) rally by ~ 47% since September 2012.
With interest rates and bond yields at very low levels, the probability of bond yields falling further is slim. Also, with the economy beginning to improve, inflation, which has lagged so far, could pick up as well. This could lead to a rate hike, at least a mild one. As a result, bonds could underperform going forward.
Within the bond market, high yield bonds (JNK) could be a good option. High yield bonds tend to outperform when the economy improves and interest rates rise. Caution is advised, however, as this type of investing is a high-risk strategy. For example, a further dip in crude prices could lead to energy-related (USO) high yield bonds defaulting.