The U.S. bond market is showing signs of strain, but higher yields are also creating new opportunities for fixed-income investors. The 10-year Treasury yield moved above 5% on Tuesday, reaching its highest level since 2007 and prompting renewed concerns about the outlook for bonds.
Investors have increasingly favored short- and ultra-short-term bonds to limit exposure to the volatility that has hurt bond prices as interest rates climbed. Concerns over inflation, the federal deficit and broader economic conditions have added to the pressure. However, higher yields are changing the risk-reward equation for investors considering medium-term bonds, particularly those with maturities between five and 10 years.
Higher Yields Offer More Cushion
Markets broadly expect the Federal Reserve to raise its target federal funds rate by 0.25 percentage point, amid higher oil prices and the ongoing war with Iran. Higher rates could further increase borrowing costs for consumers, but they also offer bond investors a more attractive starting point for income.
“As yields have gotten higher, there’s much more cushion than there was in 2020,” said Alec Lucas, director of fixed income for manager research at Morningstar.
Investors seeking less interest-rate exposure can continue using money market funds, while some may favor dividend-paying stocks for income. At a 5% yield, however, a $1 million investment in a 10-year Treasury would generate about $50,000 in annual interest income, or $500,000 over 10 years, assuming the rate and investment remain unchanged.
Why ‘Escape Velocity’ Matters?
Bond prices generally move opposite to higher yields , meaning rising rates can push bond prices lower. But higher starting yields can provide a larger income cushion against those declines. Cullen Roche, founder of Discipline Funds, uses the term “escape velocity” to describe the point at which bond income can offset losses caused by rising interest rates. His framework identifies where a bond’s yield equals its modified duration. At that point, one year of interest income can offset the price decline caused by a 1% increase in rates.
Roche said bonds with maturities of five years or less currently have a stronger cushion, while that protection becomes smaller as maturities lengthen.
Elevated Rates Could Persist
Bond strategists expect higher yields to remain elevated for some time. BMO Wealth Management’s Carol Schleif said geopolitical risks and higher energy prices could keep pressure on yields.
Meanwhile, respondents to the CNBC Fed Survey expect at least two rate hikes this year, suggesting investors may continue to face an environment of elevated interest rates and ongoing bond-market volatility.
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