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How Fearful Should You Be of Rising Rates?

The market may have already prepared for your fears.

Eric Jacobson, 05/20/2010

If there's a single worry that seems widely shared among many--though not all--bond investors these days, it's that the Fed will hike short-term rates sometime soon, that a sharp rise in longer-term Treasury yields will follow, and that the whole exercise will decimate the bond portfolios of ordinary investors. The fact is, though, that higher bond yields have already been factored into bond prices. Therefore, even though it may seem counterintuitive, even if you expect higher rates, there may not be a need to tinker with your fixed-income allocation.

It's an axiom of investing that broadly held worries tend to work themselves into market prices well before the events in question actually occur. In the case of bonds, that would mean one who believes higher bond yields have sufficiently been "priced in" to the market shouldn't feel a need to make drastically different decisions about where to invest along the market's spectrum of maturities (that is, yield curve).

And in fact, Morningstar has begun to hear from fund managers who do believe that current prices have sufficiently priced in future rates, and who find themselves having to defend and explain their reasoning for what amount to neutral (rather than defensive) interest-rate positions in their portfolios. If rates are going to rise, say many inquisitors, then why aren't their funds fleeing for the short end of the maturity spectrum?

The Market Knows Your Fears
The answer has to do with a concept known as the forward yield curve. Those interested in delving into details of this concept can look at Vanguard's recently released paper that does a nice job of illustrating it, though the explanation is complex. In essence, it's about taking the differences among current bond yields from maturity to maturity and inferring from that data whether the market expects those differences to be larger or smaller in the future. Put another way, the current level of Treasury yields at all of the different available maturities reflects implicit market expectations for the level of yields at different times in the future.

The math necessary to work out those numbers is messy (and explained in some detail in the Vanguard paper), but as of May 17, for example, data from Bloomberg showed that by 2015, the market expected one-year Treasury yields to be 4.5%, up from 0.4%, and 10-year notes to be around 4.7%, up from 3.6%. The key takeaway is that, unless one has a strong conviction that those numbers are too high or too low, it doesn't make a lot of sense to let fear drastically influence your yield-curve allocations or interest-rate exposure.

What If The Market's Wrong?
Of course, not every bond manager is positioned in a neutral posture today, and among those who are, not every one provides the same reasoning. Even if accounting for the "pricing in" concept, there's evidence to suggest that such macro-level market expectations can frequently prove wrong.

Given today's global economic instabilities, there are plausible scenarios that could result in longer-maturity Treasury yields that remain stable or even fall further over the next few years. There are skeptics, meanwhile, who believe that, despite a lack of historical precedent in the United States, recent government deficit and borrowing levels are going to shoot Treasury yields into the stratosphere. If you count yourself in either camp, then bold action may suit your taste. If you're thinking about abandoning bonds entirely, just remember that even in the worst of times, bonds still typically provide some cushion compared with losses in stocks.

Again, if you're less convinced of those extremes but still think the market's forward rate estimates are too high or too low, big portfolio shifts may not be the best response. Vanguard lays out five scenarios in its paper, for example, that argue that the ability to reinvest at higher yields can actually provide an advantage to investors in longer maturities--even if fiscal and inflation concerns accelerate more dramatically than the market currently anticipates and bonds initially suffer significant negative returns in the short run.

None of that means that investors should ignore their bond portfolios or that there's anything inherently wrong with choosing a short maturity offering to help you sleep better at night. For those trying to optimize their allocations for long-term investment plans, however, failing to respond to rising-rate fear could just be the best response of all.

Eric Jacobson is a fund analyst with Morningstar.

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