The 10-Year Yield May Be Flashing A Warning Sign

Friday’s one-day move of over 7% in the 10-Year Treasury Note yield caught many fixed-income investors off guard as better than expected payroll numbers signaled that the economy is still improving. This sent stocks to new all-time highs and put significant downward pressure on bond prices. The interest rate on 10-Year Treasuries is currently sitting at 1.75% which is more than 25% higher than the 1.40% low it hit back in July 2012.

The chart above shows the benchmark interest rate index is currently sitting right at its 200-day moving average. In addition, its price is nearly flat over the last 52-weeks despite all of the intermediate term volatility.

However, the real interesting story for 10-Year Treasury Yields on Friday is that there have only been eight other instances in the last 50 years with larger one-day percentage changes.

When you plot these dates on the chart below, you get a picture for how these one-day moves often signal an inflection point or larger trend change in yields.

Fixed-income investors should be aware that these one-day moves often are the start of a renewed surge in rates or a blow off top that reverses into a continued downtrend. We all know that one day does not make a trend, but it pays to be attentive to historical cues that often signal broader changes in the bond market.

In this case, I would not be surprised to see a continued run in the 10-Year back to its 2013 high of 2.00% which may correspond with an extension of the current stock market rally. However, if stocks reverse, we will see a flight to quality that may send yields back near their lows.

Managing The Risk In Your Bond Portfolio

The bond market has been a very steady machine over the last year with relatively little volatility to speak of. In fact, it has been nearly 8 months since the iShares 7-10 Year Treasury Bond Fund (IEF) fell over 0.85% in a single day (as it did on Friday). This low volatility has been an opportunity for both capital appreciation and income in longer duration fixed-income securities.

However, today was a stark reminder of how quickly interest rate risk can creep back into the bond market. This list of widely held ETFs bore the brunt of Friday’s interest rate climb:

• iShares 20+ Yr Treasury Bond Fund (TLT) -2.36%
• iShares 7-10 Yr Treasury Bond Fund (IEF) -0.85%
• iShares Investment Grade Corp Bond Fund (LQD) -0.94%
• iShares 10+ Yr Corporate Bond Fund (CLY) -1.29%
• iShares TIPS Bond Fund (TIP) -0.68%

However, the story was quite different for short-duration bonds that weathered the storm quite well.

• Vanguard Short Term Corp Bond Fund (VCSH) -0.04%
• iShares Floating Rate Note (FLOT) +0.03%
• iShares 1-3 Yr Treasury Bond Fund (SHY) -0.04%
• iShares 0-5 Yr TIPS Bond Fund (STIP) +0.07%

The lesson here is that duration and security selection is key to determining your game plan to combat rising interest rates. Your strategy may include lowering your average duration, purchasing inflation sensitive funds like floating rate and bank loan securities, as well as buying a rising rate fund such as the ProShares Short 7-10 Year Treasury Bond Fund (TBX).

Each of these options have their own pros and cons that may make them attractive for income investors given their asset allocation, cost basis and long-term goals. My personal strategy over the last year has been to lower the average duration of my portfolio and seek out higher yielding securities with lower credit quality such as the PIMCO 0-5 Year High Yield Treasury Bond Fund (HYS). Ultimately, I believe we are going to see spreads widen and high yield will come under pressure, but right now the trend is still our friend.

The Final Word

Investing in passively-managed ETFs for fixed-income has its advantages, but you have to be vigilant when it comes to interest rate risk. I would recommend keeping a close eye on the 10 and 30-Year Treasury Yields as they relate to the average duration of your holdings. Ultimately it is healthy for a short-term rise in interest rates, which may present a more attractive entry point for new money flowing into bonds this year.