How will interest rates affect bond prices in 2021?

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One of the most notable trends in the investment markets in early 2021 was the sudden change in the interest rate environment. 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 the end of March.

Interest rates are a function of expectations for the economy, inflation and supply and demand for bonds,” says Tom Hainlin, national investment strategist at U.S. Bank Wealth Management. “The signals we’re seeing today indicate that the upward pressure on bond yields was driven by expectations of a stronger economy going forward.”

The apparent anticipation among investors of an improved economic outlook may be due to a combination of factors. These include significant fiscal stimulus from the federal government, ongoing monetary stimulus by the Federal Reserve, and optimism that growing distribution of COVID-19 vaccines will continue to tamp down the virus and help the economy return to pre-pandemic conditions.

The impact of positive investor sentiment about the direction of the economy isn’t limited to Treasury bonds. Yields for corporate bonds rose as well in the first part of the year, though not necessarily as dramatically as was 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.

Anticipating modest movement

While the rapid change in yields on 10-year U.S. Treasuries that occurred in the 1st quarter may raise fears of another spike in interest rates, there are reasons to believe that changes from this point will be more modest. “Yields will likely go higher, but we’ve seen some moderation since March,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “For starters, while many are prepared for inflation to tick higher, we don’t expect a dramatic, sustained change. 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.” The Fed has been using its assets to buy bonds, helping to bring more balance to the supply-demand equation, and put downward pressure on interest rates.

The door remains open for Treasury bond yields to resume an upward trend, possibly even this year. “Our expectation today is that yields will cap at around the 2 percent level,” says Eric Freedman, chief investment officer at U.S. Bank Wealth Management. Freedman anticipates that after a surge of economic activity in 2021, the U.S. economy will likely settle into a more modest period of growth in 2022. That could put a lid on any significant rise in interest rates.

The Fed eyes the situation more closely

The broad bond market can be sensitive to changes in the Fed’s interest rate policy, but it’s showing little hurry to alter its current zero interest rate policy on the Fed Funds rates. “Federal Reserve Chairman Jerome Powell has had several opportunities to indicate his concern about issues like an overheated economy or rising inflation,” says Freedman. “He continues to emphasize that the Fed will keep its policy intact.”

After the end of the June meeting of the Federal Open Market Committee, the Fed signaled that it’s sticking with its plan to maintain the target Fed Funds rate at 0 percent into 2023. This is the benchmark overnight lending rate banks charge each other. Some Fed officials indicated that up to two rate hikes could occur in 2023, but Chairman Powell seemed to suggest that rate hikes even two years out is far from a certainty. An important consideration for the Fed is the fact that more than nine million Americans remained unemployed as of the end of June, 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

Despite the change in interest rates so far in 2021, 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 the end of June. 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 2010.1

With yields still historically low, Hainlin notes, “it’s a challenging time to be a conservative bond investor.” 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. “If the upward trend in interest rates continues, the coming months will be 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 healthcare 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 the 2 percent level 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. In addition, the Fed has been regularly making purchases of mortgage-backed securities to help add liquidity to that market.

Municipal bond yields have been reasonably stable 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 included funding for state and local governments,” notes Haworth. “This means these bond issuers are 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 currently under consideration in Congress.

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Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer's ability to make principal and interest payments. 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.