The U.S. 10-year Treasury yield has been on a roller coaster this year. The highly watched rate briefly topped the pivotal 1.5% level on Monday morning after seeing its biggest weekly jump since March in the prior week.
While shorter-term yields will remain anchored at a low level until the Federal Reserve begins raising rates, the steepening yield curve is reverberating through bond and equity markets and showing up in the performance of several ETFs.
US 10-Year Treasury Yield
After beginning the year below 1%, the measure peaked at 1.75% at the end of March before slipping all the way down to 1.13% by the beginning of August. But the 10-year yield has been on a steady climb since then. Yields were rising on a more hawkish-than-expected tone from the Federal Reserve after the conclusion of last week’s Fed meeting.
The central bank had indicated it would begin tapering COVID-era bond purchases later this year and raising rates as soon as next year.
Effect On Bonds
Fluctuating yields have their most direct effect on bonds. Bond prices have an inverse relationship with yields. As yields rise, bond prices fall. Longer-duration bonds are the most sensitive to changes in interest rates as they have the longest amount of time (and most coupon payments at the current fixed rate) until maturity.
The differing sensitivity to changes in rates can be seen by comparing performance of several fixed income ETFs with differing durations. Duration is a measure of sensitivity to changes in interest rates, and while it is not the same as a bond’s maturity, they are positively related.
The PIMCO Enhanced Short Maturity Active ETF (MINT) is a short-term fixed income ETF with current duration around 0.6 years. The iShares Core U.S. Aggregate Bond ETF (AGG) has a similar duration to the broad investment-grade bond universe, currently around 6.3 years. And the iShares 20+ Year Treasury Bond ETF (TLT) is a long-term bond ETF, with current duration of 19.0 years.
Shorter-duration MINT is slightly positive year-to-date, while TLT has recovered after falling nearly 15% through March. AGG’s performance follows a similar trend, but is muted relative to that of TLT due to its lower duration.
Should rates continue to rise, more negative performance could lie ahead for AGG and TLT.
Head Winds For Growth
Rising yields can also put downward pressure on stocks, particularly tech growth names. Valuations of growth stocks are sensitive to investors’ perception of future inflation. High levels of inflation mean the present value of future cash flows will be worth less in today’s dollars.
This growth is typically financed through debt as well, so it also means companies would face higher costs of borrowing.
Longer-term yields reflect investors’ views of future growth and levels of inflation. This explains why rising rates often weigh on the performance of growth stocks.
Various ETFs that offer exposure to “growthy” areas of the market have seen mixed results this year.
The ARK Innovation ETF (ARKK) has had a rough patch of performance this year, down 7.2% in spite of double-digit gains for the broad market. This actively managed ETF focuses on companies that are involved with or benefit from disruptive innovation. (Read: ARK ETF Investors Not Getting Seasick)
The Invesco QQQ Trust (QQQ) is underperforming SPY by about 1.6% so far year-to-date. This ETF, which tracks the Nasdaq-100, has considerable tech exposure, but is not a pure “tech” fund.
More tech-focused ETFs such as the SPDR S&P Software & Services ETF (XSW) have fared slightly worse this year, though have still notched impressive gains.
Though it is not the only factor that plays into the performance of growth stocks held within these ETFs, rising rates could place downward pressure on this area of the market going forward.
Banks Could Benefit
Financials stocks tend to be the beneficiary of a steepening yield curve. This helps to explain the performance of the Financial Select Sector SPDR Fund (XLF), which is outperforming the SPDR S&P 500 ETF Trust (SPY) year-to-date.
Banks typically do well in a steepening yield curve environment. Banks usually borrow at short-term rates and lend at long-term rates. The wider the gap between short- and long-term rates, the more profitable the environment is for the banking sector.
Banks are the largest industry weighting within XLF, making up about 38% of the portfolio. For more concentrated exposure to banks, investors can consider the SPDR S&P Bank ETF (KBE). This ETF tracks an equal-weighted index of U.S. banking firms.
KBE had been outperforming both XLF and SPY earlier in the year, though performance dropped off as longer-term rates slumped over the summer. The ETF could see another period of outperformance over both XLF and SPY if the yield curve continues to steepen.