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With investors processing another 0.75 percentage point rate hike by the Federal Reserve, government bonds could be a signal of market turmoil.
Ahead of news from the Fed, the policy-sensitive 2-year Treasury yield climbed to 4.006% on Wednesday, the highest level since October 2007, and the 10-year Treasury benchmark reached 3.561% after hitting an 11-year high this week .
When short-term government bonds have a higher yield than long-term bonds, known as yield curve inversions, it is seen as a warning sign of a future recession. And the closely watched spread between the 2-year and 10-year Treasuries remains inverted.
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“Higher bond yields are bad news for the stock market and its investors,” said financial planner Paul Winter, owner of Five Seasons Financial Planning in Salt Lake City.
Higher bond yields create more competition for funds that would otherwise go to the stock market, Winter said, and with higher Treasury yields used in the calculation to rate stocks, analysts can reduce future expected cash flows.
In addition, it may be less attractive for companies to issue bonds for share buybacks, a way for profitable companies to return money to shareholders, Winter said.
How the Federal Reserve’s Rate Hikes Affect Bond Yields
Market interest rates and bond prices generally move in opposite directions, meaning higher interest rates lower the value of bonds. There is also an inverse relationship between bond prices and yields, which rise as the value of bonds falls.
Fed rate hikes have contributed somewhat to higher bond yields, Winter said, with the impact varying across the Treasury yield curve.
“The further you stray on the yield curve and the more your credit quality goes down, the less Fed rate hikes affect interest rates,” he said.
That’s a major reason for the inverted yield curve this year, with 2-year rates rising much more dramatically than 10- or 30-year rates, he said.
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Now is a good time to rethink your portfolio diversification to see if changes are needed, such as realigning assets with your risk tolerance, said Jon Ulin, a CFP and CEO of Ulin & Co. Wealth Management in Boca Raton, Florida.
On the bond side, advisors look at what is called duration, which measures the sensitivity of bonds to changes in interest rates. Expressed in years, duration factors in the coupon, maturity and yield paid over the maturity.
While clients welcome higher bond yields, Ulin suggests keeping maturities short and minimizing exposure to long-term bonds as interest rates rise. “Maturity risk can take a bite out of your savings over the next year, regardless of industry or credit quality,” he said.
Winter suggests tilting equity allocations toward “value and quality,” typically trading for less than the asset’s worth, rather than growth stocks, which can be expected to deliver above-average returns. Often, value investors look for undervalued companies that are expected to rise over time.
“Investors need to remain disciplined and patient, as always, but especially if they believe interest rates will continue to rise,” he added.