Bond yields have risen quickly since the election alongside expectations that a Trump presidency would follow through on a promise to increase infrastructure spending, which would lead to greater growth and higher inflation. The Federal Reserve followed the election in December by resuming federal funds tightening and hiking its target rate by 0.25%. The move was expected, but the market was surprised by the announcement that the Fed plans three additional 0.25% increases in 2017. Together, these news events caused the benchmark 10-year Treasury yield to spike to 2.6%, the highest level in two years, after hitting a record low of 1.3% this summer.
Inflation has been muted since the financial crisis in 2008 with the average annual inflation rate hovering below the Federal Reserve’s target of 2%. The actions taken by central banks around the world to stimulate economic growth and push inflation higher are starting to take hold. Deflation concerns have abated as oil prices have bounced and housing and commodity prices have stabilized. Higher inflation can signal a growing economy, but the downside is that inflation erodes the real returns of investments. The real returns of bonds have been negative over the last several years due to historically low rates.
A real rate of return is the annual percentage return realized on an investment, adjusted against changes in prices due to factors like inflation. For example, if a bond is yielding 1% and inflation is running at 2% then an investor’s real rate of return is negative 1%. In order to maintain purchasing power, investments need a return more than the rate of inflation. Historically, the real rate of return on the 10-year Treasury has averaged about 2%. With inflation currently running close to 2%, the 10-year Treasury should be yielding around 4% to keep in line with historical returns.
Rising interest rates are negative for bonds prices, but higher rates mean bond buyers today will be rewarded with more income. In order to protect your bond portfolio against high rates, we recommend buying bonds across a range of short maturities and laddering the structures: lower durations will decrease the volatility of the portfolio and maturing bonds will allow you take advantage of potential opportunities to reinvest at higher rates.
The nearly 40-year bond bull market appears to be coming to an end, but we believe the selloff will be slow and orderly as yields go back up gradually. A stronger U.S. dollar will constrain inflation and give the Fed more reason to pause or increase rates slowly. 2017 will be another tough year for the bond market as yields are still historically low and opportunities to make money are limited. We continue to believe keeping durations short and holding some cash or cash equivalents is prudent, although bond prices are starting to look more attractive.
Individual investment positions detailed in this post should not be construed as a recommendation to purchase or sell the security. Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Employees and/or owners of Nelson Roberts Investment Advisors, LLC may have a position securities mentioned in this post. Please contact us for a complete list of portfolio holdings. For additional information please contact us at 650-322-4000.