Earlier this month, the Federal Reserve raised interest rates for the second time this year and the eighth time since 2015. Ongoing Fed tightening was forecast before the start of 2018 with many fixed income market observers forecasting up to four rate hikes by the Fed this year. Interest rate hikes aren’t great for bond prices.
The most recent Federal Open Market Committee (FOMC) meeting minutes hint at two more rate hikes before the end of 2018, moves that could hamper bonds. After all, conventional wisdom holds that higher interest rates are bad news for bonds. As of June 15, 10-year Treasury yields resided at 2.92%. Higher yields mean lower bond prices.
Even with the potential vulnerability of bonds, bond funds remain popular destinations for investors. When it comes to exchange traded funds (ETFs), three of this year’s top 10 ETFs in terms of new assets added are bond funds. Still, investors’ enthusiasm for some fixed income funds should obfuscate the myriad issues facing bond prices.
“Treasury yields rose, but the yield curve temporarily flattened to its lowest level since September 2007 after the Fed announcement, signaling fears of future economic weakness or a policy mistake by too aggressive central bank tightening,” reports CNBC.
Dangers of an Inverted Curve
A major issue facing fixed income investors and bonds generally is the flattening yield curve, which can portend ominous macro economic trends.
“While the Fed has slowly pushed short-term rates higher, geopolitical tensions are constraining long-term rates, flattening the yield curve,” said State Street Global Advisors (SSgA) in a recent note. “Without a commensurate rise in long-term rates, worries are escalating that we could face an inverted yield curve—a reliable predictor of recession.”
Following the Fed’s most recent rate hike, the yields on 2-year and 10-year treasuries were less than 0.40% apart, indicating an inverted yield curve is a real possibility. Inverted yield curves can punish bond prices. There are funds that can help investors when interest rates rise and even as the yield curve flattens.
One corner of the fixed income market that can help investors deal with volatility in bond prices is floating rate notes. The SPDR Bloomberg Barclays Investment Grade Floating Rate ETF (NYSEARCA:FLRN) is one of several ETFs offering exposure to floaters.
The $3.22 billion FLRN provides “exposure to debt instruments that pay a variable coupon rate, a majority of which are based on the 3-month LIBOR, with a fixed spread,” according to SsgA.
FLRN’s option-adjusted duration is just 0.12 years.
One area where bond prices are rising is with convertible bonds, or those corporate bonds that can later be converted into shares of the issuer’s stock. The SPDR Bloomberg Barclays Convertible Securities ETF (NYSEARCA:CWB), the largest convertibles ETF on the market, is up nearly 9% year-to-date and residing near all-time highs.
Convertible bonds historically deliver higher prices in the face of rising interest rates, owing the equity-like traits of these bonds.
The $4.47 billion CWB holds nearly 170 bonds with an average yield-to-worst of 2.74%. CWB has its perks, but it is not a lock for higher prices, particularly if the market turns against high-yield debt, the classification for most convertibles. Nearly 80% of CWB’s holdings are rated junk or not rated at all.
In the current environment, companies are actually issuing more convertible debt.
“U.S. issuance this year on track for the highest level since before the financial crisis, spurred by tax changes that boost the allure of the securities and demand for a cushion against higher equity volatility,” according to Bloomberg.
Todd Shriber does not own any of the aforementioned securities.
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