How will interest rates affect bond prices in 2021?

Updated September 30 | Market news

With potential changes coming to Federal Reserve policies, it’s a good time for investors to revisit portfolio bond allocations.

The interest rate environment has proven to be somewhat surprising in a year when strong economic growth has been one of the underlying stories. A benchmark measure of the fixed income market, the 10-year U.S. Treasury note, tells the story. Its yield rose from 0.93 percent at the end of 2020 to more than 1.74 percent by mid-March. To many, that was expected given the solid economic recovery that was underway. But then yields proceeded to come down, dropping to a low of 1.19 percent in mid-July. They moved a bit higher from that point, but never reaching their peak levels of late March.

The rise in interest rates in the early part of the year seemed to match investor expectations for the economy. Key factors that seemed to boost the economy included significant fiscal stimulus from the federal government, ongoing monetary stimulus by the Federal Reserve, and optimism that implementation of COVID-19 vaccines would tamp down the COVID-19 virus and help the economy return to pre-pandemic conditions.

The impact of positive investor sentiment about the direction of the economy was also reflected in other parts of the bond market early in the year. Yields for corporate bonds also rose, though not necessarily as dramatically as is the case with Treasuries. Municipal bond yields have been more stable.

There is an inverse relationship between bond yields and bond prices. When yields rise, bond prices fall. This is a function of supply and demand in the marketplace. Demand for bonds declined early in the year, forcing issuers of new bonds to offer higher yields to attract buyers. That reduced the value of existing bonds that were issued at lower interest rates.

A shift in sentiment began to take hold in the early spring. Demand for bonds increased, pushing interest rates down again. While they did not fall as low as they did in 2020, when yields spent much of the year below the 1.0 percent level, the decline was still noticeable.

Inflation is another consideration

Typically movements in interest rates tend to follow long-term inflation trends. If inflation is moving higher, interest rates tend to follow suit. If inflation stays low, there is usually less pressure on interest rates. Yet as government reports of inflation levels topping the 5 percent mark, the highest since 2008, occurred in mid-summer, interest rates barely moved.

Why has the bond market seemed less concerned about inflation? “While many anticipated inflation would tick higher, we don’t expect a dramatic, sustained change, says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. Second, if interest rates are rising too fast, the Federal Reserve (the Fed) may step in and add liquidity to the bond market to help temper that trend.” If the Fed uses its assets to buy bonds, it helps bring more balance to the supply-demand equation, keeping interest rates lower. The Fed has been a buyer of Treasury bonds for more than a year, but has indicated it plans to reduce its purchases begin late in 2021 and perhaps curtail its purchasing activity completely by mid-2022.

“Interest rates could drift a bit higher, but we see a pause in the yield upturn rather than moving in a straight line up,” says Eric Freedman, chief investment officer at U.S. Bank Wealth Management Freedman anticipates that after a surge of economic activity at the end of 2020 and the first half of 2021, the U.S. economy will likely settle into a more modest period of growth. That could put a lid on any significant rise in interest rates.

The Fed stays on the sidelines

An additional factor that may contribute to what remains a modestly favorable environment for bonds is that the Fed is holding fast to its stance of maintaining a 0 percent target rate for the Fed Funds rate it manages through next year. This is the benchmark overnight lending rate banks charge each other. While that policy guidance remains in tact, some members of the Federal Open Market Committee anticipate that the Fed may begin raising short-term rates by the latter part of 2022.

An important consideration for the Fed is the fact that more than eight million Americans remained unemployed as of the end of August, a significant concern for the long-term health of the economy. Higher unemployment could allow the Fed to justify sticking to its current interest rate plan.

Freedman also notes that the European Central Bank seems committed to maintaining its own interventionist stance, designed to maintain liquidity in the fixed income markets. “There’s no sign that central banks are flinching from their current stance,” notes Freedman. In short, there is little likelihood that Fed policies will have an appreciable impact on domestic bond markets.

Yields remain historically low

Even though interest rates are higher than they were at the end of 2020, yields on a historical basis are still very low. At the end of 2019, before COVID-19 became an overriding concern, 10-year Treasury notes yielded 1.88 percent, still higher than where they stood at their March peak. For most of the past decade, yields ranged between 2 and 3 percent. 10-year Treasuries have not generated a yield of as high as 4 percent since 2010.

With yields still historically low, “it’s a challenging time to be a conservative bond investor,” notes Tom Hainlin, national investment strategist, U.S. Bank Wealth Management. He adds that along with receiving a nominal interest payout from Treasury bonds, those who currently hold such bonds are also losing ground in principal value. “When interest rates resume their upward trend, the environment will be more difficult for these investors,” says Hainlin.

Haworth notes that with interest rates still at such low levels, many investors can generate more income from equities than from bonds. “Dividend yields on some stocks have outpaced the yield on certain types of bonds,” says Haworth. “This makes the benefit of owning Treasuries appear even less evident, at least from a yield perspective.”

Reverberations in the stock market could be felt if Treasury bond yields move much beyond the 2 percent level. Assuming higher interest rates occur in conjunction with stronger economic growth, it would likely benefit cyclical sectors of the economy and reward those stocks. “Higher bond yields could create challenges for growth companies in the technology and health care sectors,” says Hainlin. He points out that valuations for stocks like these, that pay little or no dividends, are based on expectations for future cash flows. “In a higher interest rate environment, the future value of those cash flows is less attractive, and that can result in lower valuations for these stocks.” In this environment, investors may want to consider putting more of their portfolio to work in stocks that are not as reliant on future cash flows in determining their valuation. Yet this scenario of interest rates rising beyond 2 percent in the near future seems far from certain.

Finding opportunity in the bond market

If the opportunity in Treasury bonds appears to be limited in the current environment, what are the best options for bond investors? One to explore is taking more risk with your bond selections. Corporate bonds may be better positioned than Treasuries in the current environment. They typically generate higher yields than government bonds. This can include both high-grade bonds (those with ratings of BBB or higher by the rating agency Moody’s) as well as high-yielding bonds from below investment-grade issuers. The added risk comes from the fact that unlike Treasuries, corporate bonds are not backed by the full faith and credit of the United States. Instead, investors must rely on the ability of corporate issuers to make timely payments of interest and principal.

“Given the favorable outlook for the economy, this is a time when investors can reasonably consider taking on more risk in their bond allocations,” says Hainlin. An important consideration with high yield bond issuers is the default risk they carry. “With the economy growing as it is,” adds Hainlin, “that should be less of a concern for investors. Many of these issuers will be in a stronger financial position, an environment that usually results in fewer defaults.”

Other segments of the fixed income market to consider are non-agency and non-government guaranteed mortgage securities. They appear to be well-positioned given the current strength of the housing market. However, there is a chance the market for mortgage securities will be impacted if the Fed decides to pull back from the billions of dollars in bond purchases it has been making in the market.

Municipal bond yields have not moved significantly so far in 2021. Haworth sees this as another opportunity for investors who can benefit from income that is generally exempt from federal income tax. “The $1.9 trillion American Relief Plan includes funding for state and local governments,” notes Haworth. “This means these bond issuers will be in better financial shape, reducing the potential default risk of municipal bonds.” The same benefits to state and local bond issuers may result from a sizable infrastructure investment plan that is expected to receive Congressional approval.

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The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issues of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is generally free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes.