If one were to make a ranked list of which asset classes and securities are most fun to watch, fixed income would be near the bottom, just ahead of money market funds. You certainly won’t find any Redditors calling for bonds to rocket to the moon. However, the impression that bonds are boring is not at all accurate. In fact, fixed income can tell us a lot about our economic futures and where investors think our markets may go from here.
Over the last few months, a lot of investment talk has centred around rising long-term bond rates. Since Aug. 1, 2020, the U.S. 10-year Treasury yield—the benchmark government bond that gets the most attention—has climbed by 124%, and it’s risen by 65% since the start of 2021, according to S&P Capital IQ. Over those same time frames, yields on the 30-year U.S. Treasury bonds have jumped by 54% and 40%, respectively. Canada’s 10-year benchmark bond yields have skyrocketed even higher, climbing by 223% between August 2020 and March 4, 2021, and 108% since January 1. Yields now stand at are now 1.54%, 2.3% and 1.4%, respectively.
This is all happening at the same as the Federal Reserve and Bank of Canada are saying they won’t raise overnight interest rates—the short-term lending rate that gets the most media attention—until 2023. Currently, both countries’ overnight rates sit around 0.25%, which is the lowest they have ever been, other than during the 2008 recession. It may seem like an odd thing for overnight rates to stay put while longer-term yields soar, but the divergence is a sign that better economic times may be on their way.
Brighter future ahead
Longer-term bond yields have long predicted, fairly accurately, though not perfectly, the direction of economic growth. The 10-year Treasury started to plummet in June 2007, well before most people were talking about a Great Recession, and it started to fall again in 2019, well before the word “pandemic” became part of our everyday lexicon. Rates experienced a massive drop in mid-February 2020, a couple of weeks before the stock market collapse.
While that may be just two examples in the long history of economic ups and downs, a 2006 paper from the New York Federal Reserve said: “Since the 1980s, an extensive literature has developed in support of the yield curve as a reliable predictor of recessions and future economic activity more generally. Indeed, studies have linked the slope of the yield curve to subsequent changes in GDP, consumption, industrial production and investment.”
So if yield direction is a look into the future, then there’s good news for those still struggling to picture themselves at dinner parties and beach vacations as they read this: The recent rise in long-term rates indicates investors are feeling optimistic that life will return to some sort of normalcy over the next few years. (When that normalcy will come, though, is still unclear—the 2-year bond yields, which are more real-time indicators of economic growth, have barely budged over the last six months, which means it’s not time to party just yet.)
Pay attention to inflation
While rising bond yields may be a sign that vaccines and other treatments are working, they can also be a warning sign of more troubling issues lie ahead. Long term fixed income yields usually climb with inflation, which is a rise in the price of goods or services. If people think that inflation will rise too quickly, then bond yields will jump, too, as investors usually want the payments they receive from their bonds to cover the cost of living.
Economists generally want inflation to rise by a bit—the Federal Reserve is targeting a long-term average of 2%—but if it climbs too quickly, the economy could crash again. As Trevor Galon, chief investment officer at Calgary’s Matco Financial put it to me, if everyone thinks prices will rise dramatically over the next few months, they’ll spend as much money as they can today instead of gradually over time. As well, if inflation soars, the items people do need to buy—groceries, for instance—will become too expensive to purchase.
People are concerned about inflation. There’s worry that as we start spending again, and as the job market rebounds, prices could start rising faster than economists would like. There’s also an idea that too much government spending (and there has been a lot) could ultimately lead to higher inflation, because, according to the St. Louis Fed, “an increase in government purchases might drive up the cost of production. In turn, this would drive up inflation.”
However, Galon points out that this is not always the case, and he doesn’t think inflation will get out of hand, anyway—too many jobs remain unfilled and you need a tight labour market for prices to really rise. Still, if bond yields jump more dramatically, that could be a sign of an inflation-led economic collapse.
Potentially muted returns
So what do rising bond yields mean for investors? One is that the bond part of your portfolio will likely decline in price. When rates rise, fixed income prices fall as investors sell off lower-rate bonds at lower prices to buy bonds with higher yields. Given that most people are holding bond mutual funds and ETFs (bonds are hard to buy individually) you should expect more muted fixed-income returns for a while.
Rising rates can impact equity returns, too, especially in sectors with high dividend yields, such as utilities and real estate investment trusts (REITs). At some point, it becomes more attractive to buy bonds with higher rates (they’re much less volatile than stocks) than to subject your savings to the ups and downs of the stock market. We’re not there yet, Galon says, but that time could come, especially if 10-year rates get close to 3%.
Higher rates also increase borrowing costs for companies, which reduces earnings potential, while valuations tend to fall in rising-rate environments, which can negatively impact stock prices. (Why? It’s a bit complicated, but here’s a good primer on the impact rates have on discounted cash flows if you want to know more.) Given that rising rates impact both bond and stock prices, Galon thinks portfolio returns could be muted in 2021.
But what about mortgage rates, you ask? Generally, lending rates are based on both the 5-year Government of Canada bond yield and prime rates, both of which are much more dependent than long-term rates on the overnight rate that’s currently at 0.25%. The five-year rate, however, can rise, like the 10 and 30-year, in anticipation of a brighter future ahead – and it has been climbing. It’s up 130% since January.
While mortgage rates will remain low as long as the overnight rate stays where it is, it will get tougher for lenders to offer the rock bottom rates we’ve seen over the last few months. “We’ve probably seen mortgage rates get as low as they’re going to go in this economic cycle,” says Galon, who suggests locking into a five-year fixed rate term now, if possible.
See how exciting the bond market can be? While it’s no GameStop, bond yields are still worth keeping an eye on. At least, in this moment, it can help you feel a little better about the future.