ETF Trends
ETF Trends

We began February with a yield on the 10-year Treasury of 1.68% and today sit at 2.14%.1 All the concerns and talk of maybe even no rate rise this year that we saw in January, have turned to frequent mention of a rate rise beginning in June. So what are bond investors to do? Is this finally the year of rising rates and what impact does that have?

Yes, it is well understood that the Federal Reserve will be raising the federal funds rate off of the 0.0-0.25% target that we have seen since the financial crisis. The timing is anyone’s guess, but at the end of the day markets are forward looking mechanisms and have/will price this move in long before it actually happens. Even if the Fed does start to raise rates this year, we don’t expect them to do so rapidly and we don’t expect their actions to have a dramatic impact on the 5- and 10-year Treasuries.

That being said, one thing we know over the last year is that interest rate moves have surprised nearly everyone. But what about investors that are concerned rates will make a sizable move up and with that, how various fixed income asset classes will perform in this environment? Let’s take a look at some data points.

One primary way to evaluate interest rate sensitivity is with duration, a measure of the price change of a fixed-income security in response to a change in interest rates. Per this calculation, rates and prices move in the opposite direction, so an increase in rates would produce a decline in price. Below are the durations and yields for various fixed income asset classes.2

As you can see in the chart above, municipal bonds and the 5-year Treasury carry a duration near 5 years, investment grade bonds have a duration of over 7 years, and high yield bonds offer the lowest duration of just about 4 years, meaning the high yield asset class carries the lowest sensitivity to interest rates. In other words, all else equal, a given increase in interest rates will move the price of investment grade bonds down significantly more than high yield bonds.

The number of years to maturity for the asset is one factor in determining duration, but the starting yield also plays an important role. After a big run in 2014, municipals now offer a yield to worst only slightly over that generated by the 5-year Treasury, both under 2%. The yield to worst on the investment grade index is about 3%, while the broader high yield index offers a yield to worst of twice that, over 6%. So not only do high yield bonds offer the lowest duration, they also offer the highest yield. So how does that play into a rising rate environment? Well, it means that high yield bonds are much less interest rate sensitive than these other fixed income alternatives. And while the traditional adage in fixed income is that as interest rates go up, prices on bonds go down, that doesn’t factor in the yield being received which may outweigh the price decline, all else equal. So investors need to consider both yield and duration.

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