Over the past three decades, interest rates have steadily declined. Now that rates are finally rising, fixed-income as well as equity exchange traded fund investors should be wary of certain areas in the markets.
With yields rising, investors would naturally assume long-term Treasuries should fall – yields and bond prices have an inverse relationship, so a rising rate environment would correspond with declining bond prices.
“Yet rising-rate pain hasn’t been limited to long-term Treasuries,” writes Christine Benz, Morningstar‘s director of personal finance. “A host of disparate categories, from emerging markets to REITs, have experienced large losses recently.”
On the other hand, Benz also warns that investors shouldn’t dump everything that is rate-sensitive. Over the last week, Treasury yields dipped again as bonds rallied on Bernanke’s reassurances that the Fed won’t change its policies any time soon. Moreover, slowing economic growth and a stronger dollar could have attributed to recent troubles, along with rising rates.
Benz points out several potential problematic areas, along with why they were struggling between May 1 and July 5:
Treasury Inflation-Protected Securities (TIPS) fell 7.9%. TIPS, like Treasuries with longer durations, suffered in a rising rate environment. However, tame inflation has further reduced demand for securities with build-in inflation protection. [Rising Rates and Low Inflation a Toxic Mix For TIPS ETFs]
“TIPS remain the most direct way to hedge against inflation, and therefore they can serve a valuable role in a portfolio,” Benz said. “But their recent weakness underscores their vulnerabilities in certain environments and the importance of having an appropriate time horizon for owning them.”
Emerging Market Debt declined 9.6%. Emerging debt were among the worst performing fixed-income assets as rates increased. Rising Treasury yields makes riskier emerging market bonds less attractive – the tighter yield spreads would no longer justify the added risk. Moreover, emerging market local currencies have been depreciating against the U.S. dollar, which further dragged on bonds denominated in the currencies. [Rising Rates Weigh on Emerging Market Bond ETFs]
“The recent tremors underscore the bonds’ vulnerabilities in certain environments,” Benz added. “If you have an emerging-markets bond fund in your portfolio, it’s worth checking up on its strategy and positioning.”
Emerging Market Stocks dropped 10.1%. Along with rising rates, emerging markets weakened on slowing growth in key markets, notably China and India, and the appreciating U.S. dollar. Benz, though, points out that the current macroeconomic pessimism could translate to buying opportunities in cheaply valuated emerging stocks.
Utilities dipped 6.2%. Utilities typically suffered when bond yields rise as investors shift away from safe-haven dividend stocks for better opportunities. Moreover, utilities have already experienced robust returns. If an investor does decide to stick to utilities, it is important to note that the sector only makes up 3% of the total U.S. market. [ETF Chart of the Day: Utilities]
“The average utilities stock in Morningstar’s equity analysts’ coverage universe is about 5% overvalued currently,” Benz said. “In addition to so-so valuations, utilities are apt to remain rate-sensitive for the foreseeable future.”
Real Estate Investment Trusts decreased 7.4%. REITs also suffer when bond yields rise. Additionally, REITs have been generating robust returns over the past five years and are beginning to look overvalued as yields diminished, according to Morningstar analysts. Investors still interested in REITs should be aware that the sector makes up 3.6% of the total U.S. market. [Mortgage REIT ETFs Hit as Interest Rates Surge]
For more information on bond funds, visit our bond ETFs category.
Max Chen contributed to this article.