How rising interest rates are impacting the bond market

May 20, 2022 | Market news

The interest rate environment changed dramatically in 2022. The benchmark 10-year U.S. Treasury note yielded 1.5% at the end of 2021, but quickly moved higher. By May, the yield topped 3%. This was a negative development for bond investors because of the 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. When demand for bonds declines, issuers of new bonds are forced to offer higher yields to attract buyers. That reduces the value of existing bonds that were issued at lower interest rates. Bondholders were hard hit by this environment in the opening months of the year.

A range of developments, from additional COVID-19 variants to continued inflation threats to a major shift in monetary policy by the Federal Reserve and Russia’s invasion of Ukraine, altered the landscape for investors in 2022. The U.S economy was strong in 2021, growing at its fastest annual rate in 37 years.1 With that growth came a sudden surge of inflation, with the consumer price index (CPI) rising as much as 8.5% for the 12-month period ending in March, its highest reading since 1981.2 Movements in interest rates tend to follow long-term growth and inflation trends. If inflation is moving higher, interest rates tend to follow suit. Nevertheless, the yield on the benchmark 10-year Treasury note held fairly steady through 2021.

In early 2022, there was a major shift in investor sentiment, as interest rates rose swiftly. The yield on the 10-year Treasury topped 3% by early May.3  “Bond yields rose primarily because the Federal Reserve pivoted to a much more hawkish position,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management.

The question now is whether that trend will continue.

The Fed’s central role in interest rate policy

The Fed uses interest rates as a tool to cool the economy in hopes of leveling off the inflation rate. Fed chairman Jerome Powell and other members of the policy-making Federal Open Market Committee (FOMC) made clear that The Fed’s “easy money” policies had to change in response to the inflation threat. One of the Fed’s operating mandates is to help keep inflation under control, so the sudden uptrend in the cost of living led the Fed to pursue different strategies.

The Fed’s moves in 2022 reversed a strategy enacted in 2020 in the early days of the COVID-19 pandemic. At that time, the Fed cut the short-term interest rate it controls, the federal funds rate, to near 0%. It also initiated an infusion of liquidity into the bond market to help keep interest rates low and encourage investment. The Fed began purchasing $120 billion of bonds each month, including Treasury and mortgage-backed securities.

In March 2022, the Fed raised the fed funds rate by 0.25%, the first increase since 2018. That was just the start. Powell stated that interest rate hikes would continue until inflation is under control. He emphasized that “if we determine that we need to tighten beyond common measures of neutral and into a more restrictive stance, we will do that as well.” This opened the possibility that in some months, rate hikes might be higher than the typical adjustment of 0.25%.4 In May, Powell’s statement proved prophetic, as the Fed raised rates by another 0.50%.

The Fed also ended its bond-buying program in March 2022. The FOMC now plans to begin reducing the size of its bond portfolio (adding more supply to the market) later in the year. The Fed’s new stance on both the fed funds rate and its bond portfolio represents a major departure from its previous accommodative policy, and it clearly had an impact on the broader bond market.

A rapid market reaction

Does the Fed’s significant policy reversal mean that interest rates will continue trending higher as they have through the early months of 2022? Merz says the bond market tends to be driven more by investor expectations of future policy. “We believe that much of the Fed’s aggressive shift in 2022 is already priced into the market,” says Merz. “While rates could move higher from here, the changes from this point are likely to be more modest.”

This is due in part to the fact that at today’s levels, bond yields look more attractive to investors. Yields are pushed higher when demand for bonds begins to lag. Merz sees a different situation today than where things stood at the outset of 2022. “Investors are getting paid much more than they were just a short time ago for buying bonds,” says Merz. That should help elevate demand for bonds, which would limit how much farther yields will rise.

Rob Haworth, senior investment strategy director at U.S. Bank, agrees. Haworth notes that currently, real interest rates (a measure of Treasury yields minus the inflation rate), which are in negative territory, have moved in a positive direction. “The Fed is sending a message that it’s trying to get real interest rates to move higher.”

“We still see opportunities in vehicles like reinsurance, which is uncorrelated to traditional stock and bond investments.”

Haworth also notes that the conflict in Ukraine and the economic fallout from it could have an impact on the pace of the Fed’s actions over the course of the year. “It’s more of a balancing act because of the war,” says Haworth. “Along with watching the inflation trends, the Fed will also be keeping an eye on whether consumer spending falters.” If there are significant economic ramifications as a result of the conflict in Eastern Europe, the Fed may have to account for that as it sets its monetary policy.

Bond yields remain moderate by historical measures

Even as the yield on 10-year Treasuries hovers around the 3% level, it’s still in a historically low range. Still, bond yields have not moved significantly higher for an extended period of time. For most of the past decade, yields ranged between 2 and 3%. 10-year Treasuries have not generated a yield of as high as 4% since 2010.2

“We expect the inflation rate to ease over the course of 2022,” says Haworth. “But it will still be above normal. The Fed won’t achieve its long-term goal of a 2% inflation rate (as measured by the Consumer Price Index) in 2022,” according to Haworth. He notes that consensus projections are for inflation to come in at the 5-6% level.

Merz says if inflation proves more persistent during the year, it could put upward pressure on long-term interest rates. “With the Fed cutting back its presence in the bond market as it ends its bond purchases, investors will have to do more heavy lifting to absorb supply.”

The Fed’s revised policy stance along with ongoing inflation concerns are among the reasons investors need to be prepared for a changing environment. “2022 will be very unlike 2021 for investors. The potential for more volatility in the markets is high and the range of potential outcomes is wide,” says Merz.

Finding opportunity in the bond market

As yields across the bond market trend higher, what are the best options for bond investors? The recent rise in interest rates should create a more favorable environment for investors. “We’re putting more emphasis on core bond holdings,” says Merz. “We suggest a fairly neutral stance in a bond portfolio, with the majority invested in investment grade bonds.” This can include Treasury bonds, municipal bonds and higher rated corporate bonds.

Merz sees an important benefit for bond investors concentrating more of their bond positions in high-quality segments of the fixed income market. “This is a way to add considerable portfolio diversification to help manage a portfolio that includes equities,” says Merz. While the early months of 2022 proved to be a rare occasion where both stocks and bonds declined in value, Merz believes that over the long run, holding high quality bonds will typically help smooth the volatility in an investor’s diversified portfolio.

However, investors may wish to consider other aspects of the fixed income market that offer unique potential. “We still see opportunities in vehicles like reinsurance, which is uncorrelated to traditional stock and bond investments.” These are firms that provide financial backing of the risks taken by insurance companies. Merz notes that the yields offered on reinsurance products are very attractive in today’s environment. Non-agency mortgage-backed securities also look attractive. These are bonds not backed by the federal government, but by the collateral value of the homes they finance. “Given the sharp rise in home values today, these bonds are well collateralized and that should help solidify their position,” says Merz.

While Treasury Inflation Protected Securities (TIPS) might seem to be an appealing option in a high inflation environment, Merz is less enthusiastic. “We do not explicitly suggest TIPs on a tactical basis due to low absolute return expectations,” he notes. They can, however, provide benefits as a small part of a diversified, long-term fixed income portfolio. Merz notes that TIPS offer minimal credit risk and the potential for relative outperformance over standard Treasury securities if inflation is higher than what investors currently price in to bond markets.

Talk to your wealth professional for more information about how to position fixed income investments as part of a diversified portfolio.

Will high inflation persist into 2022?
U.S. Bank investment strategists weigh in

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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.

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.

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