The global interest rate environment is changing. Last week, bond yields in the U.S., U.K., Europe, Japan, Australia and New Zealand all hit new highs for the year. As I discuss in my weekly commentary, be ready for more rate volatility.
Notably, this backup in yields is not occurring as a result of any increase in inflation expectations. For example, U.S. 10-year Treasury yields closed in on 2.50 percent last week, roughly 50 basis points (0.50 percent) higher than their late April levels. But 10-year inflation expectations remain below their May peak. In other words, interest rates are not rising because of inflation fears, but because rates are starting to normalize from the unsustainably low levels reached earlier this year.
We think rates are likely to grind higher over the course of the year, but much of the adjustment may have already taken place. While still low by historical standards, the spike in yields has returned some value to long duration bonds, which now appear more reasonable, or at least less overpriced. This assertion at least partly stems from the fact that yields are likely to stay low for longer: Inflation is low and relatively stable, demand is supported by institutional investors buying because they need to meet their obligations and an aging population favors a shift towards income. The combination of these factors means real interest rates are likely to trade at a lower level than was the case 10 or 20 years ago.
For investors, the implications are not to load up on bonds, but to tactically look for areas of relative value within fixed income.
The asset class is starting to stabilize after a torrent of supply put it under pressure for most of the spring. Long-dated municipals currently offer the potential opportunity for an incremental pickup in yield relative to Treasuries.
High Yield Bonds
Despite recent underperformance, they still offer a reasonable yield, and with the economy improving, there is less risk of a material rise in defaults.
The backup in yield has returned some value to the category, even though we don’t expect much in the way of inflation. While investors probably don’t want to overweight TIPS in a portfolio, those whose portfolios are dominated by traditional bonds may want to consider some exposure to inflation-protected instruments.
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.
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