The volatility in bonds over the past month has been a wake-up call to many investors who had been complacent with their fixed-income portfolios. The catalyst for this volatility was recent comments from the Federal Reserve about tapering its asset purchase program; the resulting skittishness sent the 10-year Treasury yield to its highest level of the year at over 2.1%.
Consequently, bond prices (which move inversely to bond yields) have suffered some of their worst monthly losses in recent memory. In fact, you would have to go all the way back to November 2010 when the Federal Reserve launched QE2 to see this big of a drop in Treasury bond prices over such a short period of time.
One of the most well-known exchange-traded funds that is susceptible to the machinations of intermediate-term interest rates is the iShares 7-10 Year Treasury Bond ETF (IEF). This ETF commands $4.5 billion invested in 22 U.S. Treasury bonds with a weighted-average maturity of 8.29 years. The current 30-day SEC yield on IEF is 1.48%, and its expense ratio is just 0.15%. So far this month, IEF has fallen 2.84% through May 29.
The chart of IEF at right shows a great deal of support right at $105, which is close to where we sit right now. If it pierces this level with conviction, it could be the sign of a new breakdown in Treasury bonds that will lead fixed-income prices even lower. Higher yields and lower bond prices will ultimately lead to higher mortgage rates, auto loans and other credit facilities … which will directly affect the economic recovery efforts.
One obstacle that is stacked against the case for higher interest rates is the lofty levels that the stock market has attained this year. If we start to see a breakdown in stock prices, more than likely that will start a flight to quality in Treasuries that will push interest rates lower. Investors still view bonds as a safer bet than stocks during periods of volatility, which makes funds like IEF even more attractive at these levels.
I don’t believe that the Federal Reserve is going to taper its bond purchases early or begin a significant shift in its zero-interest-rate policy until we see a stronger recovery in the job market. That being said, it’s important to look at the overall duration of your fixed-income portfolio to determine if you have significant exposure to interest-rate risk. We will eventually see an important shift in the risk dynamic of Treasury bonds, leading to heavy selling in this sector. You will need to be nimble with your income portfolio in order to sidestep that decline — all the more reason to evaluate strategies for risk management.
If you have already experienced the brunt of this interest-rate rise, I recommend you continue to hold quality fixed-income for the time being in anticipation of a bond rally. Investors with heavy stock exposure might even look to make some opportunistic purchases at these levels to hedge their portfolios.
With the right game plan in place, you can weather this interest-rate storm and come out on top a winner.
At the time of publication, Fabian had no positions in the securities mentioned.