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Yields Are Rising

Treasury 2 yr

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The graph above is of the 2-year treasury note yield. At 2.58%, it is at a 10-year high – and looks like it could continue to rise.

The stock market has had a rocky start to 2018. One of the big reasons is rising interest rates. There is a trade-off between stocks and bonds – as bond yields fall, stocks become more attractive to investors. This is based upon a couple of reasons: (1) lower interest rates mean that corporations borrow at lower rates, and the difference between the higher and the lower rates equates to increased net income for shareholders, which makes stock prices rise (all else being equal) – so rising rates mean just the opposite, lower earnings and lower stock prices; and (2) when valuing stocks, you are really looking at a discount of a company’s future earnings – those earnings are discounted using current short term treasury rates, so falling rates will yield a lower discount and produce a higher valuation – while rising rates yield a higher discount and produce a lower valuation.

As an investment manager, we watch treasury yields very carefully. Rising yields means rising risk – the risk that your investment portfolio will go down in value. Above, we discussed how rising yields impact stock prices, but they also negatively impact bond prices.

As yields rise, the value of bonds goes down. Think of it like this: you bought a 2-year treasury last year at a yield of 1.35%, but today you could buy one yielding 2.58%. The yield has almost doubled over the course of a year, so if you want to sell that bond to someone else, your bond yielding 1.35% with a remaining life of 12-months provides less return than the current bond yielding 2.58% with 24-months remaining life. You would have to sell your bond at a discount so that the yield moves from 1.35% to the current yield on a similar new bond with 12-months remaining life. Today, a 1-year treasury note yields 2.36%, or a full 1% above your bond. That is a big discount, or loss in value from its face value, that you would have to take to sell the bond today.

Rising interest rates are bad for both stocks and bonds as shown above. So what does an investor do? Sell everything and move to cash?

No, part of managing investments for clients means that you have to work hard to make money even at times when extraneous forces are presenting headwinds to stocks and bonds.

As far as stocks go, you have to find ways to deal with the two issues discussed above: earnings and valuation.

To deal with the earnings issue, you need to focus on: (1) companies that have no debt (not always possible) or at least companies that have a lower level of debt than their industry average; and (2) industries that do not need to borrow as much as other industries to operate their businesses. Reviewing ratios of debt to equity for individual companies, and comparing them to other companies in their industry, will help with the first issue above. Over-weighting your industry allocations to industries with little borrowing needs, like biotech and technology, while under-weighting industries with heavy borrowing needs, like manufacturers, help with the second issue.

As far as bonds go, you need to focus on building a ladder of individual short-term bonds and CD’s (say one to three years in duration), short-duration mortgage bonds that repay principal along with their interest payments, and adjustable rate bonds (we focus on mutual funds for these last two) all are good hedges against rising rates. The short-term ladder allows you to hold your bonds to maturity (since selling early can cause losses due to the discount to face value as shown in the discussion above) and then reinvest your proceeds in higher yields. The mutual funds are defensive by the nature of their investment portfolios – you just need to be very careful when looking at a mortgage bond mutual fund to make sure the average duration is short. Additionally, if rising inflation is the proximate cause of the rise in yields, mutual funds that focus on TIPS (treasury inflation protection securities) can be a successful investment as well.

For the classic rock fans out there, here is a classic: the Animals playing House Of The Rising Sun

For those who are fans of today’s music, here is a cut from Jurassic World: Rise by Skillet

–Mark