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Bond prices are decreasing and interest rates are rising. What can investors do to get ready?

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Inflation takes center stage

Movements in interest rates tend to follow long-term growth and inflation trends. If inflation is moving higher, interest rates tend to follow suit. If inflation stays low, there is usually less upward pressure on interest rates. Since early 2021, inflation has been a prominent story as it soared to levels not seen in 40 years. The annual change in the cost of living as measured by the Consumer Price Index was 7.9% for the 12-month period ending February 2022.2

This environment will likely result in interest rates rising in 2022. One reason for this is a major shift in Federal Reserve (Fed) monetary policy.

A more aggressive posture by the Fed

The Fed entered 2022 ready to shift gears regarding monetary policy. Fed chairman Jerome Powell and other members of the policy-making Federal Open Market Committee (FOMC) made clear that The Fed’s “easy money” policies were changing in response to the inflation threat. One of the Fed’s operating mandates is to help keep inflation under control, so the sudden uptrend in the cost of living led the Fed to pursue different strategies.

In the wake of the COVID-19 pandemic in early 2020, the Fed cut the short-term interest rate it controls, the federal funds rate, to near 0%. It also initiated an infusion of liquidity into the bond market to help keep interest rates low and encourage investment. The Fed began purchasing $120 billion of bonds each month, including Treasury and mortgage-backed securities.

The Fed began reducing its monthly bond purchases in late 2021 and ended the program in early March 2022. The FOMC has also indicated that a series of interest rate hikes would occur in 2022, and that the Fed will begin reducing the size of its bond portfolio (adding more supply to the market). The Fed’s new stance represents a major departure from its previous accommodative policy.

In March 2022, the Fed raised the fed funds rate by 0.25% for the first time since 2018. That was just the start. Powell stated that interest rate hikes would continue until inflation is under control. He emphasized that “if we determine that we need to tighten beyond common measures of neutral and into a more restrictive stance, we will do that as well.” This includes the possibility that in some months, rate hikes might be higher than the typical adjustment of 0.25%.3

The combination of the Fed no longer buying bonds and possibly reducing some of its bond holdings could contribute to an upturn in interest rates. The degree to which long-term rates, such as the yield on the benchmark 10-year Treasury note, go up may determine how much leeway the Fed has to raise the federal funds rate. “If long-term rates don’t rise much from current levels, it puts some constraints around how far the Fed can increase their target federal funds rate, which influences short-term bond yields,” says Bill Merz, senior vice president and senior portfolio strategist at U.S. Bank. “They expect that since their bond-buying program appeared to help keep long-term interest rates lower, the inverse should be true as well, and long-term rates will probably begin moving up once they scale back existing bond holdings.” Merz anticipates bond yields may head higher, but not significantly. “The market has already priced in aggressive rate hikes,” says Merz, “and if the Fed is forced to limit the number of fed funds rate increases to fewer than the 6 to 7 the market currently anticipates, it could result in long-term rates falling.”

Rob Haworth, senior investment strategy director at U.S. Bank, agrees. Haworth notes that currently, real interest rates (a measure of Treasury yields minus the inflation rate) are in negative territory. “The Fed is sending a message that it’s trying to get real interest rates to move higher.”

Haworth also notes that the conflict in Ukraine and the economic fallout from it could have an impact on the pace of the Fed’s actions over the course of the year. “It’s more of a balancing act because of the war,” says Haworth. “Along with watching the inflation trends, the Fed will also be keeping an eye on whether consumer spending falters.” If there are significant economic ramifications as a result of the conflict in Eastern Europe, the Fed may have to account for that as it executes its monetary policy.

Bond yields remain historically low

Even as the yield on 10-year Treasuries hovers around the 2% level, it’s still in a historically low range. Still, bond yields have not moved significantly higher for an extended period. For most of the past decade, yields ranged between 2 and 3%. 10-year Treasuries have not generated a yield of as high as 4% since 2010.1

“To this point, investors anticipate inflation, while stickier than many expected, will moderate somewhat over time and that the Fed cannot be overly aggressive in raising interest rates in the long run,” says Merz. “Part of the reason long-term rates remain historically low are the modest expectations for long-term economic growth along with demographic and productivity trends that may impact the potential for future growth.”

Merz says if inflation proves more persistent during the year, it could put upward pressure on long-term interest rates. “With the Fed cutting back its presence in the bond market as it ends its bond purchases, investors will have to do more heavy lifting to absorb supply.”

The Fed’s revised policy stance along with ongoing inflation concerns are among the reasons investors need to be prepared for a changing environment. “2022 will be very unlike 2021 for investors. The potential for more volatility in the markets is high and the range of potential outcomes is wide,” says Merz.

Finding opportunity in the bond market

With yields on Treasury bonds expected to trend higher in the current environment, what are the best options for bond investors? Merz says it’s a challenging time. “Low yields mean lower income streams, but if yields begin to rise, it puts downward pressure on bond prices as well.” He says the safest segments of the bond markets – Treasuries, mortgage bonds backed by the government, and investment-grade corporate and municipal bonds– faced challenges at the outset of 2022 as yields rose. He still suggests these bonds make up the core of investors’ fixed income portfolios to ensure they remain well diversified, though some limited exposure to higher yielding categories may be beneficial.

“There are some unique opportunities in bonds with higher return potential,” says Merz, such as mortgage securities not backed by the government. They remain well-positioned given the current strength of the housing market, considering single-family homes serve as collateral for the bonds and outstanding loan principal falls with every mortgage loan payment.

While Treasury Inflation Protected Securities (TIPS) might seem to be an appealing option in a high inflation environment, Merz is less enthusiastic. “We do not explicitly suggest TIPS on a tactical basis due to low absolute return expectations,” he notes. They can, however, provide benefits as a small part of a diversified, long-term fixed income portfolio. Merz notes that TIPS offer minimal credit risk and the potential for relative outperformance over standard Treasury securities if inflation is higher than what investors currently price in to bond markets.

If you have significant dollars sitting in cash-equivalent investments earning low yields, Merz suggests you consider incrementally shifting a portion of those assets to your fully diversified bond portfolio. Another approach is to begin moving money into lower risk bonds with strong liquidity, low default risk and limited interest rate risk. Higher yielding bonds can be added over time, with highly rated short-term bonds (from government and investment-grade issuers) also playing a role.

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