At more than 3.1 percent, 10-year Treasury yields have reached their highest level since 2011. Meanwhile, the Standard & Poor’s 500 index has returned less than 1.6 percent year-to-date.
With numbers like these, investors have to wonder what anyone is doing in the stock market. Why take all that investment risk for 1.6 percent when you could get an almost risk-free return of more than 3 percent?
The answer: because a lot can change in 10 years and a 3 percent return won’t help you reach your long-term goals.
Rising interest rates are bad for bonds. Commitment is a form of risk. Sure, stocks are volatile and may seem untrustworthy, but at least you aren’t wedded to them for the next decade. What makes Treasurys such safe investments is the guaranteed return of your principal at maturity. But you have to wait 10 years for that to happen, and a lot can change in that time, like interest rates.
“With rising interest rates, bonds are susceptible to losses,” says Marc Odo, director of investment solutions at Swan Global Investments in Durango, Colorado.
Your 3.1 percent bond won’t look so good if other bondholders are getting 4 percent. You could sell your bond if this happens, but you’ll likely have to take a loss to do so. If you’ve realized you can get a better return elsewhere, other investors will know this, too. They won’t pay full price for your bond if new issues are providing higher yields.
[See: 7 ETFs to Buy as Interest Rates Rise.]
Adding to the pain, inflation will eat into your yield. “With the consumer price index, ex food and energy, running a bit over 2 percent, the real rate of interest on the 10-year Treasury is 1 percent or less,” says Lon Erickson, a portfolio manager at Thornburg Investment Management in Santa Fe, New Mexico. “It’ll be hard to meet long-term goals with that type of return.”
Comparatively, the average inflation-adjusted return in the stock market is about 7 percent.
Treasury yields are still low by historical standards. While the 3 percent yield marker may be psychologically important, it’s still low by historical standards, says Mark Hackett, chief of investment research at Columbus-based Nationwide. The last time rates were this low was in 2008, and before that, it was the 1950s.
Ultimately, “the yield on bonds aren’t that attractive,” Odo says. Most bond indexes have had negative year-to-date returns, he says.
The current S&P 500 dividend yield alone is about 2 percent. With “S&P companies expected to buy back stock equal to 3 percent of market cap, in a way, the economic yield to investors is roughly 5 percent,” Hackett says.
“Looking at it another way, earnings yield of the S&P [calculated as earnings divided by market cap, or the inverse of the price-earnings ratio] is 6.1 percent,” roughly double the yield on 10-year Treasurys, he says.
[Read: Why Investors Shouldn’t Panic About 3 Percent Treasury Bonds.]
Cyclical sectors continue to perform well. There’s a fear that if rates rise too fast, it could stifle economic growth, but we can’t forget that “rising interest rates are a positive signal of a healthy domestic economy,” says Martin Jarzebowski, vice president and portfolio manager of a leading small-cap fund for Pittsburgh-based Federated Investors. Earnings and GDP growth remain strong and many market sectors are continuing to perform well.
“The fundamental backdrop remains extremely attractive to equities, with 20 percent expected earnings growth this year and double digits in 2019 and 2020,” Hackett says.
“When analyzing market performance, it’s important to look under the hood at how sector composition is driving broad market trends,”Jarzebowski says. The defensive sectors have been weighing down the broad market, with consumer staples, utilities, telecommunications and real estate performing the worst year-to-date, he says.
In contrast, cyclical sectors such as energy, discretionary and financials — which benefit the most from an improving U.S. economy — are performing well, Jarzebowski says.
Instead of asking if you should abandon the stock market in favor of bonds, perhaps a better question is should you adjust your allocation to take advantage of better performing market sectors. If rising yields do prompt a sell-off, that may be a cue to buy, not sell.
News headlines shouldn’t determine your investing strategy. The real moral of the story is that reacting to news headlines seldom benefits investors, Hackett says. Just remember what happened to all the people who fled the market in 2008.
“Investors [should] take a longer-term view and not get too caught up in short-term market movements,” Erickson says.
The only reason to change your portfolio allocation is if your situation has changed. If you can no longer tolerate the the market’s volatility, getting out of stocks may be the right move.
[See: 10 Long-Term Investing Strategies That Work.]
But if you’re a long-term investor and your risk tolerance has not altered, don’t shoot yourself in the foot by committing to 3 percent for 10 years.
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Should You Switch from Stocks to Bonds as Rates Rise? originally appeared on usnews.com
