Market Minute: Interest rates and the bond market

A colleague of mine asked me to touch on fixed income this week. Ask and you shall receive…

Bond funds have been extremely popular in the past 12 months, maybe even too popular. In 2009, equity mutual funds had net outflows of $35 billion while bond funds saw $421 billion of net inflows. So far this year, investors have placed about $89 billion with bond funds, or five times the rate in the first quarter a year ago. This is somewhat surprising given the powerful stock market rally over the last 12 months.

One explanation for the staggering bond flows could be the reality check investors got regarding their true risk tolerance. Pre-crisis, I commonly heard people insist they could handle more risk in the stock market or resist the idea that bonds play an important role in meeting long-term goals. If investors became more risk adverse following the crisis, then we should expect to see a spike in flows into bond funds.

A second explanation is that people got hungry for yield as they watched the stock market soar higher and their cash earned nothing. Chasing yield is a very dangerous game, especially under the belief that bonds can’t fall in value. But bond prices can fall if the Fed is forced to raise rates aggressively to fight off inflation, which seems like a reasonable possibility, and the interest rate shock would only be made worse by the fact that short-term rates are starting from zero.

I’m not suggesting this is any reason to sell all your bonds – I hope my readers stick to a more disciplined long-term investment plan– but it is worth discussing after seeing rising yields in last week’s U.S. Treasury auctions.

Rates for U.S. Treasuries were higher last week in part due to weaker demand from foreign investors such as Japan and China, but rates also reflect concerns about the massive supply of U.S. debt flooding the market and the inflationary effect of increased government spending. (You can read more about last week’s rise in rates in a post by Cliff Reynolds here.)

A sharp rise in long-term interest rates may be the biggest risk to both stock and fixed income markets today. In fact, I would expect to see a correction in the stock market if 10-year Treasury yields were to suddenly rise from today’s level of 3.87% to 4.5% in the near-term. That is because Treasuries are the benchmark for lending across the economy. Higher Treasury yields weigh on the economy by increasing mortgage rates, corporate borrowing costs, and interest on rising government debt.

I want to re-emphasize that I would only be worried about a significant near-term rise in rates. I say this because rates will go up at some point – government borrowing needs and the economic recovery make this inevitable. Nobody can know for sure when this will happen, although the Fed will telegraph the move by removing the phrase “extended period” from their view of the duration of “exceptionally low” rates.

Thanks for reading.

Peter Lazaroff, Investment Analyst