The S&P 500’s move to all-time highs is overshadowing one of the strongest moves for bond yields so far in this millennium.
Yields on the benchmark 10-year bond are now at 2.70%, up from 1.63% from a 2013 trough set in early May. That marks one of the largest 3-month spikes in bond yields over the past 19 years.
For many analysts and economists, it is now a question of when – not if – the Federal Reserve will tighten fiscal policy as the U.S. economy improves. That is one of the reasons the economists at CIBC believe that yields will continue to rise over the next six quarters, bringing with it potentially higher payouts for new bond investors.
That begs the question: What might higher interest rates and a continued surge in bond yields mean for your overall investment portfolio?
He offered following three ways to take action amid the recent surge in yields:
1) Don’t react
Yes, yields are up more than a basis point from their lows of the year, Sizemore says. But you have to ask if the current yield of 2.7% is attractive enough to warrant a change in your overall investment strategy.
Bonds remain an important asset class for purposes of diversification and income, and he says they tend to act as “shock absorbers” in a broad portfolio.
That said, higher yields do not yet make bonds significantly more attractive to long-term investors.
“You should probably not get too excited about this move as an opportunity,” he says. The 10-year Treasury is still barely keeping up with inflation, so this is not a back-up-the-truck moment.”
Remember, also, that bond prices move counter to yields. So unless you plan on holding bonds until maturity, rising yields bring significant price risk. With 10-year yields still at less than half of their long-term average going back to 1981, investors are still not being richly compensated for taking on price risk, Sizemore says.
2) Weigh opportunity costs
Weighing opportunity costs also should be part of any bond investment analysis – the cost of doing nothing, or putting money to work elsewhere. That may be a moot point for some. Bonds remain a critical source of investment yield, especially for many retirees. They also are part of many diversified portfolios for buy-and-hold investors.
Yet there may be better opportunities in some cases for investors who are willing to take on more risk for the potential of higher yields.
In particular, Sizemore points to Real Estate Investment Trusts (REITs), a hard-hit asset class where he sees some potential values. REITs are far riskier than Treasuries, but they tend to have higher yields as a result. On a risk-reward basis, Sizemore sees some values.
REITs have been one of the hardest hit asset classes amid rising Treasury yields. But as a result, he now believes that there are attractive prices for some mortgage REITS — vehicles that invest in property mortgages and are required to pay a large percentage of any earnings as dividends.
“The sector really sold off, and most of the mortgage REITs are trading at 80 or 90 cents on the dollar versus their book value,” Sizemore says.
3) Consider a tactical approach
The bond market could be volatile in the months ahead, and some investors may seek to take advantage of that volatility.
“You could be forgiven in years past for falling asleep at the wheel and letting your bond portfolio manage itself, but not anymore,” Sizemore says.
His point: A buy-and-hold approach in the bond market even at today’s higher yields could be eroded by inflation. Also, there may be opportunities to take advantage of medium-term trends that a buy-and-hold strategy might miss.
For that reason, he is no longer holding the broad iShares Core Total U.S. Bond Market ETF (AGG) in his Strategic Growth Allocation portfolio. Instead, he has replaced it with the Pimco Total Return Fund ETF (BOND). Sizemore says that BOND has more flexibility to take advantage of yield spreads, as well as changing economic conditions.
One warning though: Active management is not a panacea. Even Bill Gross at PIMCO, one of the most respected bond market investors of all time, can underperform. The Total Return ETF, in fact, is down year-to-date in 2013.
All opinions included in this material are as of August 1, 2013 and are subject to change. The opinions and views expressed herein are of the portfolio manager and may differ from other managers, or the firm as a whole. All investments involve risk (the amount of which may vary significantly) and investment recommendations will not always be profitable. Past performance does not guarantee future results.