Can Rising Rates Work to the Advantage of Bond Investors?

Last year’s “transient” inflation is this year’s persistent problem and the Federal Reserve has shifted accordingly, lifting the Federal Funds rate from near zero to a range of 2.25-2.5%, likely on its way to 3.0% or better. This was the fastest rise in the benchmark since the Fed began using Fed funds as its target in the early 1990s (Wall Street Journal, August 26). Yields on the 10-year treasury have gone from around 1.7% to start the year to more than 3.1% in late August. And it now looks like rates will be higher, for longer, based on Fed Chair Powell’s remarks at Jackson Hole in late August (Bloomberg, August 26).

When yields rise, bond prices fall, but there is a silver lining to this for those who reinvest all or part of the income generated by their fixed income holdings: a decline in bond prices provides an opportunity to lower the average cost of their portfolio. In a market defined by steadily rising rates, reinvesting into an ETF or other bond portfolio at the lower prices can lift the effective yield over time. Should bonds rally and yields then decline in the future, the additional shares acquired through reinvestment appreciate along with the rest of the portfolio.

But not all bond funds are the same, nor do all types of bonds necessarily move in lock step with Federal Reserve policy. Different fixed income sectors may have different sensitivities to rising rates. An actively managed, multi-asset fund like our recently introduced IQ MacKay Multi-Sector Income ETF (MMSB) seeks to take advantage of these inefficiencies to maximize income and provide attractive risk-adjusted returns.

There is a view that the decline in the bond market has resulted in valuations that are meaningfully more attractive and current yields that have a greatly improved ability to generate income potential.  That’s a by-product of a bond selloff that Bloomberg and others have called “historic” (Bloomberg, July 6) and that seems to have signaled an end to what has been, with a few interruptions, a 40-year bull market in fixed income.

No one knows where the bond market will go from here, but what we do know is this: it’s now possible for investors to generate income from a diversified portfolio of fixed income instruments, with even “flight to safety” U.S. treasuries yielding around 3.0% as of this writing. Further, should rates continue to rise, a strategy of all or partial reinvestment has the potential to allow the income generated by the portfolio to rise over time as well. 

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