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Rising rates and bond markets

January 7, 2022
clock 3 MIN READ

U.S. Treasury yields have risen over the past year, with the yield on 10-year Treasurys climbing by roughly 60 basis points over the 12 months ending December 31. The rise in yields has been driven by several factors, including the rollout of COVID-19 vaccines and reopenings that have supported economic growth. The reopenings, along with sizable fiscal stimulus and supply chain bottlenecks, have contributed to increased inflation, as well as heightened inflation expectations, which have also put further upward pressure on yields. 

Because bond prices move inversely to yields, some fixed-income investors are understandably concerned about falling bond prices. While seeing a price decline can be disconcerting, we believe investment-grade bonds should continue to provide important diversification benefits for investment portfolios and positive returns over both intermediate and longer time horizons (even in the unlikely case of a longstanding move to significantly higher bond yields). 

Why own bonds?

With interest rates still at historically low levels, some investors are asking whether there is still a role for core, investment-grade bonds in a diversified portfolio. We believe there is. First, bonds can provide meaningful income generation. While the current income received from bonds is quite low compared to history, we believe the relationship to cash and yields on riskier assets are within reason as compared to those of the last 25 years.

With no other consideration than the comparison of current yield levels to historical averages, an investor might conclude that core bonds are overvalued. However, just because core bond yields are at historic lows, they aren’t necessarily overvalued owing to where the yields on other asset classes sit (the opportunity cost). An investor who desires greater income might have to take on additional risk/duration/illiquidity. As with any portfolio repositioning, the change in exposure comes with tradeoffs that should be balanced with other goals and objectives. In other words, we think that the current level of core bond yields can be justified given everything else in the current state of financial markets. 

Additionally, bonds still provide valuable diversification benefits. Because the returns on high-quality bonds tend to behave differently than the returns on riskier, growth-oriented assets like stocks, they can help lower the volatility of an overall portfolio. In other words, in an optimal investment portfolio, some assets should rise when other assets fall—which is often what happens in the relationship between stock and investment-grade bonds.

A multi-decade tailwind

A nearly four-decade-long downtrend in interest rates, as shown in Exhibit 1 (download the full commentary to see exhibits), provided a longstanding boost to bond returns. The broad downtrend in rates continued into mid-2020, falling to record lows in many countries as the global pandemic took hold. Interest rates have since moved higher, thanks to the stronger growth and inflation outlooks fostered by forceful policy measures and the arrival of effective vaccines. Thus, the more interesting (and perhaps pressing) question is how serious the risk of rising interest rates is to future returns on investors’ bond holdings. 

Keep reading. Download the full commentary.

Important Information

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice and is intended for educational purposes only.

There are risks involved with investing, including possible loss of principal. Bonds and bond funds will decrease in value as interest rates rise.

Diversification may not protect against market risk.

Information provided by SEI Investments Management Corporation, a wholly-owned subsidiary of SEI Investments Company.

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