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]