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March 16, 2021 | GSAM Connect

Rising Rates: Friend or Foe?

An abrupt rise in interest rates this year has fixed-income investors grappling with seeing their bond allocation in the red for the first time in a few years.

Interest rates have been on the rise since late summer when the 10-Year Treasury yield bottomed at 0.52% (Exhibit 1). The slow and gradual pace of the increase didn’t upset markets much. In fact, some investors hardly seemed to realize rates were rising, and long-duration growth equities generally continued to exhibit strong performance throughout the second half of the year.

However, when the tempo quickened and bond yields jumped in early 2021, a sense of alarm started to spread through the market, and some investors began to review their outlook, especially as it relates to inflation and policy.

EXHIBIT 1: Rates Have Moved Nearly 100 Bps Since Last Summer, with the Pace Having Picked Up Year to Date

Source: GSAM, Federal Reserve Bank of St. Louis. As of February 28, 2021. Past performance does not guarantee future results, which may vary.

 

As we noted in Pause for an Inflation and Policy Reality Check, we expect rates to trend higher this year. But understanding what’s driving them higher is important. Here are a few things to keep in mind:

Bond Investors Just Got a Raise. Higher yields are a good thing for bond portfolios. They can add up to higher income, as yield is the primary driver of return in fixed income. We think of it as a bond’s engine. For instance, with 10-year Treasury yields ending last month at 1.44%, yields are now nearly 100 basis points higher than they were late last summer. This adds up to additional income. And starting yield matters. Investing at current levels means expected returns are higher than they were a few months ago.

Don't Forget About Roll. Think about roll like this: an investor who buys a 10-year bond and holds it for a year ends up with a nine-year bond. All else equal, in addition to the coupon on the 10-year bond, the investor also picks up the yield differential between the 10-year and 9-year bond as the bond matures and “rolls” to a 9-year maturity, which is reflected by a higher bond price.

With yields low by historic standards and short-term rates near zero, the yield curve has steepened. In our view, the potential benefit of rolling down the yield curve is more attractive than it has been in a while, creating greater income potential.

Sudden Moves Are Rare. Swift changes in the bond market cause investors to focus on the sudden change in price. And during periods of elevated volatility, investors may have a tendency to think what’s happening now will persist. We don’t think the rise in rates that we’ve seen lately is likely to continue uninterrupted. Since January 1, the 10-year US Treasury yield has climbed over 50 basis points (as of 2/28/2021). Historically, meaningful movements in the 10Y Treasury (month over month changes of at least 30 basis points) have happened less than 15% of the time1

Even with higher yields, we think high-quality (investment grade) bond valuations are still broadly attractive. Now may be a good time for investors to think about the value that high quality fixed income securities can provide in their core bond portfolios.

 

1 Source: GSAM, Bloomberg Barclays. January 31, 1981 through February 28, 2021. 

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