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As investors digest another 0.75 percentage point interest rate hike by the Federal Reserve, government bonds may signal tightness in the markets.
Ahead of the news from the Federal Reserve, the policy-sensitive 2-year Treasury yield rose to 4.006% on Wednesday, the highest since October 2007, and the 10-year Treasury index reached 3.561% after hitting an 11-year high this week.
When short-term government bonds have higher yields than long-term bonds, which are known as yield curve inversions, they are seen as a warning sign of a future recession. And the closely watched spread between 2-year and 10-year Treasuries continues to flip.
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“High bond yields are bad news for the stock market and its investors,” said certified financial planner Paul Winter, owner of Five Seasons Financial Planning in Salt Lake City.
Winter said higher bond yields create more competition for funds that would otherwise go to the stock market, and with higher bond yields used in the calculation to value stocks, analysts may reduce projected cash flows in the future.
Moreover, issuing bonds to buy back shares may be less attractive to companies, and it’s a way for profitable companies to return cash to shareholders, Winter said.
How does a Fed rate hike affect bond yields?
Market interest rates and bond prices usually move in opposite directions, which means that higher rates lead to lower bond values. There is also an inverse relationship between bond prices and yields, which rise as bond values fall.
Winter said the Fed rate hike has somewhat contributed to higher bond yields, with the effect varying across the Treasury yield curve.
“The further away you are from the yield curve and the lower the credit quality, the less impact a Fed rate hike will have on interest rates,” he said.
That’s a big reason for the inverted yield curve this year, he said, as two-year bond yields have risen significantly more than 10- or 30-year yields.
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John Olin, CFP President and CEO, Ulin & Co. Wealth Management in Boca Raton, Florida It’s a good time to reconsider your portfolio diversification to see if changes are needed, such as reorganizing assets to match your risk tolerance.
On the bond side, advisors monitor the so-called duration, and measure the sensitivity of bonds to interest rate changes. Expressed in years, the factors of the term in the coupon, the time to maturity and the return paid during the term.
While clients welcome higher bond yields, Olin suggests keeping tenures short and reducing exposure to long-term bonds as interest rates rise. “Term risk may wipe out your savings over the next year, regardless of sector or credit quality,” he said.
Winter suggests tilting stock allocations toward “value and quality,” typically trading below the value of the asset, on growth stocks, which might be expected to provide above-average returns. Oftentimes, value investors are looking for companies that are undervalued and that are expected to rise over time.
“Above all else, investors must remain disciplined and patient, as always, but more specifically if they believe rates will continue to rise,” he added.
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