Exchange traded funds that track rate sensitive sectors, such as utilities and real estate investment trusts, are under pressure as the ongoing bond rout pushed Treasury yields to their highest level in four months.
Yields on benchmark 10-year Treasury notes are not hovering around 1.86% after rising 22 basis points since the start of the month.
“You have more and more signs of an upward trend in inflation, and this is one risk that markets are not pricing,” Franck Dixmier, global head of fixed income at Allianz Global Investors, told the Wall Street Journal.
Bonds are sensitive to inflationary pressures as rising consumer prices make both the income and principle worth less over time.
The improving economy has also fueled expectations for a Federal Reserve interest rate hike in its upcoming December meeting.
“People are starting to look at interest rates and where they are, and they are getting a little nervous,” Charles Comiskey, head of Treasury trading in New York at Bank of Nova Scotia, told Bloomberg. “What you are seeing is what you haven’t seen in some time – lower pricing is attracting selling.”
Consequently, with yields rising, more rate sensitive market sectors are beginning to weaken.
On Thursday, the Vanguard REIT ETF (NYSEArca: VNQ) fell 2.5%, SPDR Dow Jones REIT ETF (NYSEArca: RWR) dropped 2.4% and iShares Dow Jones US Real Estate Index Fund (NYSEArca: IYR) declined 2.2%.
[related_stories]REITs, which are traditionally popular for their attractive dividend yields, have been under pressure as improved U.S. economic data fueled inflationary pressures and speculation of a pending Federal Reserve interest rate hike. When interest rates rise, REITs’ interest payments go up, so the companies have less cash flow available for dividends. The high dividends in REITs are attractive in a low-rate environment but are less enticing once safer Treasuries show higher rates.
Meanwhile, the Utilities Select Sector SPDR (NYSEArca: XLU) decreased 0.8%, Vanguard Utilities ETF (NYSEArca: VPU) was down 0.6% and First Trust Utilities AlphaDEX Fund (NYSEArca: FXU) was 0.6% lower on Thursday.
The bond-esque utilities sector has also weakened alongside the fixed-income market as Treasury yields rose on the Fed outlook and inflationary pressures. Once the Fed eventually hikes interest rates, the higher rates will make fixed-income instruments more attractive on a relative basis, and bond-like equities, like utilities, less enticing. Consequently, utilities may remain flat or underperform other segments of the equities market once rates start ticking higher.
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