Bond investors are witnessing the worst start to the year since 2015, as they sell off their debt on expectations that coronavirus vaccines will successfully aid recovery in the US economy, but lead to higher inflation, the Financial Times reported.
The Bloomberg Barclays Multiverse index, that tracks $70 trillion worth of debt, has dropped 1.9% in value, accounting for price changes and interest payments, since the end of 2020, the FT said.
If sustained at this level, it would mark the bond market’s worst quarterly performance in three years and the sharpest setback to the start of the year since the first quarter of 2015.
Longer-term US Treasuries have lost more than 9% in total return terms, according to a Bloomberg Barclays index of US government bonds. The 30-year US yield crossed the 2% threshold last reached in the middle of February 2020, reaching a closing point of 2.003%. Yields on 10-year government debt are also rising, having last jumped 1.9% to 1.4% on Wednesday, and even some 5-year yields are moving higher.
Bank of America said this week US yields have already reached its year-ahead target. “This is now realized, but it is over? The biggest risks to current trends include the long-term support levels nearby (yield resistance),” the bank said in a note on Monday.
Unless there is a sustained surge in inflation, rising bond yields will have a minor impact on stocks, said Richard Saperstein, chief investment officer at Treasury Partners. “Bond yields are rising right now because the market is pricing in the reopening of the economy for the post COVID-19 world and accelerating economic growth,” he said. “Widening credit spreads will likely have a greater impact on P/E’s than rising rates.”
Saperstein expects an inflation spike from March to May, because of economic scarring and elevated levels of unemployment, but does not see a sustained risk in 2021. “My advice for investors is to keep their fixed income durations shorter right now, because the income return is not enough to offset the price declines from rising rates. Any re-investments from fixed income proceeds should be limited to 3-year maturities.”
The 21st century is developing into an era of steadily declining interest rates. At the beginning of 2000, the benchmark US federal funds rate hovered around 6%; as of December 2020, it stood at 0.09%. According to the Federal Reserve, which establishes monetary policy in the United States, rates will remain near zero through at least 2023.
The interest rates lenders charge and that investments pay are pegged to the fed funds rate. So low interest rates have become a fixture in finance.
While the scenario creates advantages for some – companies and people taking out loans, or seeking to refinance their mortgages – it can be a problem for others:
Bank account-holders see their savings and money market accounts earning less.
Permanent-life insurance policyholders who fund their premiums out of their policies’ accrued cash value might have to pay out of pocket.
Those dependent on investment income find it harder to find good, safe sources of revenue.
Fixed-income investments, which largely attract retired people and workers nearing retirement, are particularly hard hit. Ideally, these conservative investments yield enough to cover investors’ expenses while also minimizing or eliminating the need to dip into principal.
But with interest rates hitting historic lows, there’s a greater onus on fixed-income investors to develop alternative investment strategies to traditional deposit accounts or US Treasury bonds. And to make the numbers work, the strategy may require taking on greater risk.
Here, in rough order of increasing risk, are some of the better-paying fixed-interest investment options during a low or declining interest rate environment – where to go when interest rates are low.
Online Savings Accounts
Traditional bank savings accounts, arguably the most plain-vanilla of investments, pay approximately the same annual rate as the monthly yield on Treasury bills – which currently is close to zero, in some cases. Online savings accounts offer a slightly higher yield. The digital banks’ lack of overhead allows them to pay out more than their brick-and-mortar counterparts. Just be sure the institution is FDIC-insured.
Certificates of Deposit
Investors sometimes also receive slightly higher rates than on savings accounts with certificates of deposits (CDs). The rate remains constant for the term of the CD, which varies from one month up to five years. Longer-term CDs pay higher rates than CDs with shorter terms.
Admittedly, CD’s locked-in rate becomes a negative factor if interest rates begin to climb. Bump-up CDs allow investors to increase the rate during the term if prevailing rates rise, sometimes up to two times. There are also no-penalty CDs that let you withdraw funds before maturity, without paying a fee.
The tradeoff to gaining these features is typically a slightly lower yield.
So, moving a portion of your fixed-income funds into a CD could be a savvy move. You could also try laddering the CDs, buying certificates with varying maturity dates, allowing for more liquidity.
Fixed-income investors often look to the bond market to achieve a higher yield than that of bank products and accounts. Bonds as a class are considered conservative and suitable for fixed-income portfolios – especially US Treasury bonds. But when Treasuries are yielding next to nothing, where else can you go?
One option: Corporate bonds, issued by companies seeking capital. They carry a higher risk than US Treasury bonds but are considered reasonably safe from default – as long as you stick to companies with strong balance sheets and financial histories.
The bonds of these companies typically carry a letter grade from an independent credit rating agency, like Moody’s, Fitch, and S&P. Look for bonds with ratings of AAA to BBB. These are considered “investment-grade” – the least-risky bonds.
High-Yield Bond ETFs
Bonds rated below BBB go by several names: “non-investment-grade,” “high-yield,” or, most notoriously, “junk bonds.” As these names imply, these bonds pay better interest rates, but are in greater risk of default, than their investment-grade counterparts.
This doesn’t mean they’re off-limits to investors, just that they’re higher-risk. For maximum safety, stick to investing via a bond exchange-traded fund (ETF), which holds a diversified portfolio of these instruments, chosen by professional money managers.
Often referred to as munis, municipal bonds are issued by cities, counties, and states to finance public construction or infrastructure projects. They offer both higher yields than bank deposit accounts and also advantages at tax time. They are exempt from federal income taxes – and also from state and local taxes, for investors who live in the state issuing them.
Munis’ stated interest rate is less than corporate bonds’ – because it’s tax-free. Often the two equal out, when you factor in the tax you’d owe on the corporate bond. Of course, the higher your tax bracket, the more advantageous the muni would be.
Like corporate bonds, munis come with letter ratings. The safest are called general obligation bonds (GO), which are backed by the issuing governmental entity itself, and not by revenue from a specific project.
Defined-maturity bond funds
While it’s possible for investors to invest directly in individual bonds and hold them until maturity, the effort can be expensive and time-consuming. Defined-maturity bond exchange-traded funds (ETFs) invest in thousands of different bonds, all held in a single fund. Each fund offers a stated maturity that dictates when the fund closes and when the net assets are distributed to investors. In essence, defined-maturity bond ETFs combine the best of both bond funds and individual bonds.
Bond fund ETF yields depend on the type of bonds held in the fund (corporate, muni, high-yield) as well as the maturity of the fund, usually from one to 10 years. Of course, bond yields fall as interest rates rise, and selling bonds as rates rise locks in losses. Because of this, bond managers continually buy and sell bonds as a means of maintaining the average maturity of the fund over time.
The financial takeaway
While finding good returns when interest rates is challenging, viable fixed-income investments do exist. Online savings accounts, CDs, and bonds are all options.
Bonds as a class are considered conservative and suitable for fixed-income portfolios. Whether individual bonds or bond funds, debt securities generally offer higher yields than many other fixed-income vehicles, like bank accounts and CDs. Of course, the greater the return, the greater the risk. That’s the cardinal rule of investing, in any climate.
But when interest rates are low, fixed-income investors must be open to loosening up their risk tolerance. At least, until interest rates start to rise again.