The yield on the 10-year Treasury bond touched 1.94% on Friday, the highest level since last spring. This has a lot of investors asking once again: “Are we finally witnessing the long-awaited rise in rates?”
My answer: A qualified yes. While a normalizing US economy should lead to higher interest rates in 2013, rates this year will likely rise slowly, erratically and only back up to about the 2.25% level of last March. As I’ve mentioned before, I believe three factors are conspiring to keep any rate rise modest:
- Central Bank Buyers: In 2012, public sector institutions – basically the Federal Reserve plus other large central banks – absorbed much of the new supply of Treasuries and they are likely to continue to be a significant source of demand this year. For instance, the Federal Reserve is still buying $45 billion in Treasuries monthly and central banks in both Japan and China are also still big buyers.
- Institutional Buyers: Demand for Treasuries also continues to come from pension funds, commercial banks and those investors looking to hedge their liabilities. For example, commercial bank holdings of government securities are up roughly $500 billion over the past 3 ½ years.
- Less supply: While large deficits are still producing a significant supply of Treasuries, other sources of long-dated paper are drying up. As a result, there is actually less supply of long-dated bonds now than five years ago.
My colleague Matt Tucker mentions even more factors keeping a lid on rates in a recent post. Still, given how rate sensitive bonds are right now, even a small backup in yields could wipe out a year’s worth of interest and impose some significant pain on bond holders.
As such, for investors with a time horizon of longer than one year, I continue to advocate an underweight to Treasuries. I instead prefer credit and municipal bonds, which are accessible through vehicles such as the iShares 10+ Year Credit Bond Fund (NYSEARCA: CLY), the iShares Investment Grade Corporate Bond Fund (NYSEARCA: LQD) and the iShares National AMT-Free Muni Bond Fund (NYSEARCA: MUB).
On the other hand, in light of the risks posed by the ongoing US budget debates and the potential for soft US growth in the first half of the year, investors with a shorter time horizon may still want to consider a benchmark weight to Treasuries.
Source: Bloomberg
Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog. You can find more of his posts here.
The author is long LQD and MUB
Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies.
A portion of MUB’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.
Hi Russ,
Great post! I wonder, if you could comment on the economy’s sensitivity to rising rates. Surely alot of growth over the past few years can be attributed to lower financing costs freeing up cash to do other things. As interest rates rise, if they continue to do so, is there a natural limiting point where the economy screams “mercy” like it did regarding $147/barrel oil in 2008? Do you think the supply demand dynamics you outlined will keep rates from ever going that high in the near term?
Cheers,
Elias
Russ K: I do think there is a pain threshold for the economy, but it would probably entail a much larger backup in yields than we are likely to see this year. I would not be particularly worried about the economic impact until the 10-year yield climbs above 2.5%. Even then this is unlikely to do much damage given that mortgage rates and other debt servicing costs would still be close to historic lows. That said, a more dramatic backup – 10-year back to 4% and real yields closer to their historic norm of around 2% – would make the consumer debt burden, which is still large by historical standards, much harder to service.
Pingback: iShares: At What Tax Rate are Munis Attractive? | Xtax