How Would the Fed’s Interest Rate Hike Impact the Bond Market?



Bond market performance

The 30-year Treasury yield was close to its month high as of March 10, 2017, at 3.20% in anticipation of an interest rate hike by the Fed on March 15, 2017. The Treasury yield across the various tenures posted a rise as the central bank is expected to have a hawkish stance in 2017. There’s also an expectation of more corporate bond supply in 2017 with the expected increase in the interest rate.

Let’s look at the bond performance with the rise in the interest rate in the following chart. The interest rate futures are expecting a 95.2% chance of the Fed increasing the rate by 25 basis points on March 15, 2017. A rising interest rate scenario is supposed to drive the yields up and bond prices down, as you can see in the following chart.

Rising yields in 2017

The bond market performance is expected to be impacted negatively by the rising interest in near future. In the above chart, you can see that the iShares 7-10 Year Treasury Bond (IEF) fell ~6% in the last six months with more expectations of an increase in the interest rate. IEF tracks the investment results of the U.S. Treasury 7-10 Year Bond Index. With the rising interest rate, investors are required to monitor the duration of the bond investments to avoid any serious impact on their returns. The duration of the bonds helps investors know the sensitivity of the fixed investment to the interest rate change as measured in years.

Actively managed bond funds (BABZ) (FWDB) tend to have high duration during the rising interest rate environment. The global bond index funds (EMB) (BNDX) have an average duration of 7.5 years and an average yield of 1.8%. The actively managed bond funds have an average duration of 5.8 years and an average yield of 3.3%. The credit quality and yield in a bond fund are also expected to provide support during the rising interest rate environment. So, investors need to watch the credit quality in addition to the investment strategy. IEF has an effective duration of 7.62 years as of December 31, 2016, according to BlackRock’s database.

In the next part, we’ll look at some of the bond ETFs that provide defense in the rising interest rate environment.

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