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Bond yields rose this week after another major rate hike by the Federal Reserve, a warning of market distress.
The policy-sensitive 2-year government bond yield climbed to 4.266% on Friday, a 15-year record, and the 10-year government bond benchmark reached 3.829%, its highest in 11 years.
Rising returns come as markets weigh in on the effects of the Fed’s policy decisions, with the Dow dropping nearly 600 points into bear market territory, tumbling to a new low for 2022.
The yield curve inversion, which occurs when short-term government bonds have higher yields than long-term bonds, is an indicator of a possible future recession.
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“Higher bond yields are bad news for the stock market and its investors,” said financial planner Paul Winter, owner of Five Seasons Financial Planning in Salt Lake City.Read:Juul sues FDA for documents said to justify e-cigarette ban
Higher bond yields create more competition for funds that would otherwise go to the stock market, Winter said, and with higher Treasury yields used in the calculation to rate stocks, analysts can reduce future expected cash flows.
In addition, it may be less attractive for companies to issue bonds for share buybacks, a way for profitable companies to return money to shareholders, Winter said.
Fed hikes ‘somewhat’ contribute to higher bond yields
Market interest rates and bond prices generally move in opposite directions, meaning higher interest rates lower the value of bonds. There is also an inverse relationship between bond prices and yields, which rise as the value of bonds falls.
Fed rate hikes have contributed somewhat to higher bond yields, Winter said, with the impact varying across the Treasury yield curve.
“The further you stray on the yield curve and the more your credit quality goes down, the less Fed rate hikes affect interest rates,” he said.
That’s a major reason for the inverted yield curve this year, with 2-year rates rising much more dramatically than 10- or 30-year rates, he said.Read:Gold Price Action Echoes Bearish Behavior as APAC Markets Fall
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Now is a good time to rethink your portfolio diversification to see if changes are needed, such as realigning assets with your risk tolerance, said Jon Ulin, a CFP and CEO of Ulin & Co. Wealth Management in Boca Raton, Florida.
On the bond side, advisors look at what is called duration, which measures the sensitivity of bonds to changes in interest rates. Expressed in years, duration factors in the coupon, maturity and yield paid over the maturity.
While clients welcome higher bond yields, Ulin suggests keeping maturities short and minimizing exposure to long-term bonds as interest rates rise.
“Maturity risk can take a bite out of your savings over the next year, regardless of industry or credit quality,” he said.
Winter suggests tilting equity allocations toward “value and quality,” typically trading for less than the asset’s worth, rather than growth stocks, which can be expected to deliver above-average returns. Often, value investors look for undervalued companies that are expected to rise over time.
“Investors need to remain disciplined and patient, as always, but especially if they believe interest rates will continue to rise,” he added.