Tuesday, February 23, 2021

Bond Yields Rising, Good Or Bad?

If you have been reading / hearing / watching the financial news recently, the term “rising bond yields” is getting commonplace. At first glance, you may think it is good news; come on, who does not like rising yields? However, this is not dividend yield, and a rising bond yield is likely to have an effect in the markets.

Bonds 101


I had written a short piece on bond yields and coupon rates back here. Essentially, bond yield is calculated by dividing the coupon rate over the current bond price. With the coupon amount (or the numerator) fixed, the bond yield ratio will fluctuate according to the changes in the denominator, which is the prevailing bond price.


With this, a rise in bond yield meant the price of bond is falling, and that led to the conclusion that bonds in general are not in favour and are facing a sell-down.


Do note that the bond yields in question are referring to U.S. treasury bonds, which are bonds issued by the U.S. government, and specifically the U.S. 10-Year Treasury Bond yield, typically used as a benchmark. Though it may look insignificant, the bond yield movements do have an influence on the U.S. equity markets and in turn the global economy as a whole.


Why Rising Yields?


The common narrative for the rising bond yield is due to the expectations of an equities market recovery, fuelled by the rapid development and deployment of COVID-19 vaccines. This probably caused a number of investors to sell bonds and start to jump back onto the stock bandwagon.


Another narrative is the expectation of inflation. The past stimulus packages and programs that had helped propped the economy had created a slosh of liquidity across the markets, resulting in equity prices going up, thus sparking a possible inflation scenario. Interest rates, which are seen as a tool against inflation, may be raised after a (very) long period of almost being at zero. Bonds and interest rates are usually inversely correlated with each other, hence the falling bond prices. You can read my post here on how interest rates could affect asset classes.


Though the previous two paragraphs may contradict each other, it is not unusual. A lot of factors are at play and it is difficult to identify the actual root causes that move the economy and markets. It is akin to 100 people playing with a big activity ball: the ball is moving around randomly, with the participants not knowing who had given the biggest push to move at a given direction. The real reason(s) behind are typically revealed at hindsight, i.e., when everything is over and clearer, which by then it is a bit late on the investing side of things.


In the world of economics and markets, everything is interlinked with one another (see my Economic Machine analogy write-up here), and if one part is affected, the rest would be affected, too, with a range of extents.


So How Now?


The answer is simple and oft repeated: Having a diversified portfolio would provide some protection and returns to your invested capital in different economic and market situations, and also wherever they move to. Inflation? Commodities (especially gold and silver) can help out a bit. Equities continuing the bull run? We have some of it and in the meantime, we can go a bit more into bonds as they are cheaper now. Interest rates rising? We have cash at hand to gain some returns from it.


While diversification should be done first on the asset class level, you can diversify further down the line by regions/countries, sectors/industries and finally to individual companies/securities. Do remember that capital moves between places which either gives the better returns and/or the better safety haven, depending on the weather of the moment.


  1. What are your thoughts on bond ETFs that hold bonds >3 yr maturity? Even if mark to market the bond prices drop, wouldn't these ETFs hold the bonds they have till maturity (or close to maturity eg: 1-2 yrs before selling them close to face value to a short term bond fund owned by the same manager). Would you consider still doing DCA of bond funds if interest rate rises seem imminent, or is the risk-return equation not favourable (at least when you DCA stocks, there is always potential for good return, whereas for bonds, you are looking at downside with not much upside)

    1. Hello World,

      Apologies for my late reply.

      ETF selection aside, overall, I still see bonds play a part in one's investment portfolio, especially if the horizon is more than 10 years. Because we do not know the future and direction of the market and economy, we tend to adopt diversification as a way to deal with it. Staying invested, staying diversified and staying the course is important, and DCA-ing is very relevant in these aspects.

      I understand your views regarding the potential upsides and downsides of stocks and bonds respectively, but to me that is how things work in diversification: some go up and some come down. Stocks and bonds (and REITs and commodities) play complementary and also substitute roles for each other (or one another). On a macro and holistic perspective, it is precisely this that protects our portfolio from uncertainty and risks.