ETFs For Rising Rates

September 26, 2017

[This article appears in our October 2017 issue of ETF Report.]

There’s a bull in the bond market—and it’s bad for investors.

At least, it’s bad for investors who depend on bonds for income. As bond prices rise, their yields inherently fall, meaning interest payments to bondholders get smaller and smaller.

“In this environment, it’s the retirees who are really hurting,” said Blair duQuesnay, principal and CIO of New Orleans-based Thirty-North Investments. “With 1-2% yields, when you were expecting closer to 6% or 7%, it’s really tough when living on a fixed income.”

With the Fed once again raising rates, some observers predict bond prices will soon cool off, and yields will again rise. Other experts caution that today’s low yields are here to stay for the foreseeable future.

Only time will tell who’s right. Either way, ETFs can help you prepare.

Understanding Low Yields
Rock-bottom yields are not new. In fact, yields have been declining since the 1980s, when then-Fed Chair Paul Volcker successfully curbed the runaway inflation of the 1970s by dramatically jacking up the federal funds rate. (The Fed funds rate is the interest rate at which banks loan each other money overnight; where the Fed funds rate goes, broad market interest rates eventually follow.)

“Since the peak, we’ve had periods of high rates and low ones, but essentially the trend has been downward for 35 years,” says duQuesnay.

But why should a higher Fed funds rate lead to lower bond yields? After all, if interest rates are moving up, wouldn’t bond coupons come along for the ride?

Yes and no. The explanation is a bit complicated.

Let’s back up a second. Unlike stocks, bonds are debt instruments. Bond issuers must make interest payments, known as coupon payments, to bondholders at an interest rate that’s set at issuance. That promise of regular income is, of course, what draws so many investors to bonds in the first place.

When market interest rates are on the rise, it means the new bonds issued today carry higher coupon rates than the bonds issued yesterday. Higher coupons mean higher income, and, of course, investors like income. As a result, prices on older bonds tend to fall, so as to stay competitive with newer bond issues.

Higher interest rates mean falling bond prices and higher yields. Lower interest rates mean rising bond prices and lower yields. Got it?

Don’t Forget Inflation
But wait a minute, you say. Didn’t we just establish that when the Fed raises rates, bond yields drop?

That’s true, and it happens in part because interest rates are intimately tied to inflation (and investor expectations around inflation).

When interest rates are low, consumers can borrow and spend more money, which grows the economy, and thus inflation. So, lower interest rates tend to result in higher inflation, and vice versa.

But higher inflation also tends to result in higher bond yields, since coupon rates on new bond issues must be juiced up to compensate for the fact that interest payments won’t retain as much value over time. Correspondingly, lower inflation usually means lower bond yields.

Inflation has remained anemic ever since the financial crisis. The U.S. economy and the economies of other developed markets have stagnated for the better part of a decade, leading to sluggish inflation and poor yields. 

The Fed tried to rev up economic growth again by slashing the Fed funds rate to almost zero—which had the effect of pressuring bond yields even lower.

QE’s Role
The Fed also tried to inject liquidity into the financial system by purchasing large amounts of Treasurys, mortgage-backed securities and other bonds in a process known as “quantitative easing.” QE purposefully pushes bond prices higher and yields lower, in the hopes investors will ditch bonds and seek yield elsewhere, thus getting more money flowing into the economy.

 

 

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