Rising Treasury Yields Are a Good Problem to Have
(Bloomberg View) -- Ten-year Treasury yields are fast approaching 3 percent, a level they haven’t breached since 2013. And in that instance, rates immediately fell again. Before then, the 3 percent level hadn’t been attained since 2011. The yields on the shorter end of the maturity spectrum have also had a healthy rise. Five-year Treasuries are now yielding more than 2.5 percent for the first time since 2010. The yield on one-year Treasuries has spiked above 2 percent for the first time since 2008.
It’s human nature to be risk-averse, so when interest rates rise the first thing investors do is worry about the risks involved. The list of worries about rising rates is long and varied:
- Principal losses in bonds
- Lower valuations in stocks because of competition from bond yields
- Higher inflation
- The end of the economic expansion
- Higher interest payments for corporations, governments and individuals in debt
Any of these risks could certainly cause investors or the economy problems. But rising rates are not all bad. There are groups and strategies that would benefit from higher interest rates:
Hedge fund managers and commodity trading advisers. The struggles of hedge funds’ performances during the past decade or so are well-documented. But the long list of reasons given for the underperformance typically misses the importance of interest rates on most hedge fund strategies. Because many funds short securities and utilize futures, they tend to carry more cash or T-bills than the standard long-only fund manager.
When you short a security, you hold the cash proceeds from the sale in the hopes that you can buy back the shares at a lower price point and pocket the difference. CTAs who invest using a trend-following approach could also benefit from higher short-term interest rates. These funds trade mostly futures and hold 80 percent to 90 percent of their assets in cash as collateral for those futures contracts.
These funds were helped by high interest rates in the 1980s and 1990s but have been penalized by lower rates in recent years. Hedge funds still have a higher hurdle rate than most fund categories because the fees are so high and the competition is so great. But higher interest rates could provide a tailwind for this much-maligned industry.
Buyers of bonds. Bond prices and interest rates are inversely related. As rates rise, bond prices fall. This relationship has made fixed-income investors nervous. Rising rates have been on the risk radar for years now.
On the other hand, the single best predictor of future long-term bond returns is the starting yield. The correlation between starting yield and the subsequent returns is around 0.9 for long-term Treasuries, 10-years and five-years. The lower the starting yield, the lower the future returns over the long haul and the higher the starting yields, the higher the future returns over the long haul.
So fixed-income investors have to experience short-term pain in the form of lower bond prices to eventually see higher expected returns over the long term. As bonds mature or come to market, investors can expect to see their yields rise, and thus, their expected returns. Unfortunately, the only cure for low returns in bonds is higher interest rates.
Savers. Anyone looking for income from certificates of deposit, money market funds or savings accounts over the past few years has been disappointed in their minuscule yields. The Federal Reserve has raised short-term interest rates and the markets have followed suit, which have helped this situation. For example, Marcus, the online bank run by Goldman Sachs, currently offers a five-year CD for 2.60 percent. In 2014, the average CD was paying closer to 0.79 percent, according to Bankrate.com. Shorter-term yields look even better when you consider you’re not locking your capital up for that long. Marcus currently offers a 12-month CD with a yield of 2.05 percent. And their online savings account pays 1.50 percent and offers better liquidity terms.
These yields aren’t exactly of the move-to-the-beach-and-live-off-the-income variety, but fixed income options for those who would like a little more security with their short-term savings are slowly but surely improving. That’s good news for retirees who may be nervous about accepting too much volatility in their portfolios.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Ben Carlson is director of institutional asset management at Ritholtz Wealth Management. He is the author of "Organizational Alpha: How to Add Value in Institutional Asset Management."
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