How will interest rates affect bond prices in 2021?

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One of the most notable trends in the investment markets in 2021 is 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 1.6 percent by mid-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 trend in bond yields is 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 implementation of COVID-19 vaccines will 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 have been rising as well, though not necessarily as dramatically as is the case with Treasuries. Municipal bond yields have risen only marginally so far this year.

There is an inverse relationship between bond yields and bond prices. When yields rise, as has been the case so far in 2021, bond prices fall. This is a function of supply and demand in the marketplace. Demand for bonds has declined this year, forcing issuers of new bonds to offer higher yields to attract buyers. That reduces 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 so far in 2021 may raise fears of the trend continuing unabated, there are reasons to believe that changes from this point will be more modest. “Yields will likely go higher, but the pace of the increase is not likely to persist,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “For starters, while many anticipate inflation to tick higher, we don’t expect a dramatic 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.” If the Fed uses its assets to buy bonds, it helps bring more balance to the supply-demand equation, keeping interest rates lower.

Nevertheless, the upward trend in Treasury bond yields is expected to continue for the immediate future. “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. “They could drift a bit higher, but we see a pause in the yield upturn rather than moving in a straight line up.” 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 stays on the sidelines

The broad bond market can be sensitive to changes in the Federal Reserve’s interest rate policy, but that doesn’t seem to be a critical concern based on its recent statements. “Federal Reserve Chairman Jerome Powell has had several opportunities to indicate his concern about issues like an overheated economy or rising inflation,” says Freedman. “So far, he has made it clear that the Fed intends to keep its policy intact.”

After the end of the March 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 through 2023. This is the benchmark overnight lending rate banks charge each other. 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, that means 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 as of mid-March. 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 yields on Treasury bonds move much beyond the 2 percent level. Assuming higher interest rates occur in conjunction with stronger economic growth, it would particularly 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.” 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.

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.

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.”

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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.