What rising long-term bond yields mean for investors

Singapore

THE bond yield on the benchmark 10-year US government note reached a one-year high last month, with the potential to climb even higher. The shift has unsettled investors who wonder how this will impact their portfolios.

Before we begin to unpack that, it is worthwhile to figure out why bond yields have been on the rise and what they mean.

The US 10-year Treasury bonds are what the US government uses to borrow money and are known as one of the safest forms of investments. Since August last year, bond yields rose from a low of 0.5 per cent to as high as 1.77 per cent in March. It is now hovering between 1.5 and 1.6 per cent.

These bond yields are seen as an economic indicator, correlating with investor sentiment on economic prospects.

With vaccines rolling out across the world and optimism high on an economic recovery after a pandemic-struck 2020, investors are less inclined to own Treasury bonds which led to a selloff as inflation expectations - the enemy of bond investors as inflation erodes the value of bonds - rears its ugly head.

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To put into context, yields are still historically lower than before - they have mostly stayed above 2 per cent in the past decade. But the sharp spike has brought market volatility as investors turn jittery.

While there was a pullback in bond markets - bond prices have fallen nearly 4 per cent year to date - it did not spill over into global equities. Stocks have gained almost 9 per cent so far this year.

This comes as yields are rising due to greater confidence in the economy, which should lift equities.

Vasu Menon, executive director of investment strategy, OCBC Bank, said: "The significant divergence between the performance of equity and bond markets this year may be a signal that nervous money is rotating out of bond markets into stock markets which should augur well for equities going forward."

In a breakdown by region, the US stock market took the lead with a gain of 10 per cent, helped by highly accommodative monetary policy from the US Fed, and aggressive stimulus by the Biden administration. Meanwhile, Asian markets gained almost 4 per cent in US dollar terms.

So investors can take heart that rising yields do not necessarily derail equity markets, especially when the economic outlook is positive and monetary policy remains accommodative.

Even in the 2013 taper tantrum in the US when bond markets were roiled, the equity markets were range-bound for a few months before continuing their upward trajectory, noted Mr Menon.

This was due to investors looking through to the broader story of the post-Global Financial Crisis recovery and a positive macro-economic outlook.

This time around, while there are reasons to remain optimistic about the outlook for global equity markets, it does not mean that there won't be some pullbacks, even in a bull market.

Occasional corrections are nerve-wracking but normal, allowing markets that are on a tear to catch their breath and prevent bubbles from forming.

Looking at the MSCI World Index last year, there were three occasions of 6 to 8 per cent corrections. They did not signal the end of the bull market as after each instance, it resumed its uptrend.

What about bonds then? Should investors shun bonds at this juncture on rising yields?

Mr Menon suggests that bond investors mitigate risks by investing in bonds with a shorter duration, as longer-dated bonds are more susceptible to rising rates.

"Within the bond space, we remain positive on high yield bonds as we expect real yields to remain low by historical standards, which should continue to spur the global search for yield," he said.

Lim Chow Kiat, CEO of Singapore sovereign wealth fund GIC, had earlier said in March that the typical balanced portfolio of 60/40 stocks and bonds no longer works as well in the current rate environment and with yields rising.

With the decline in bond returns, the 60/40 portfolio may see real returns of 1-2 per cent a year over the next decade, compared with gains of 6-8 per cent over the past 30 years, he had pointed out at a conference.

With uncertainty still looming, it would make sense for investors to diversify and take a more active approach when it comes to their portfolios to get returns.

One way to do it is through unit trusts or exchange-traded funds, which allow for diversity as they invest in a basket of stocks or bonds. For those who are more savvy, pick individual stocks and bonds to create a diversified portfolio with different asset classes, with the mix depending on risk appetite and time horizon.

For those with a stronger risk appetite, Mr Menon advises allocating more investments to equities at this juncture.

According to the OCBC Financial Wellness Index 2020, some 40 per cent of Singaporeans who are on track to their ideal retirement invested in equities. This is in comparison to those who were not on track with retirement planning, where only 23 per cent invested in equities.

With the economy picking up, cyclical stocks are now being favoured over growth stocks such as tech.

But this could be an opportunity for long-term investors who are willing to overlook near-term volatility to accumulate quality tech stocks that offer exposure to trends that are here to stay, such as cloud computing, genomics, electric vehicles and 5G.

Most industry watchers believe that there will be continued headwinds for bond yields. Some street projections pin the 10-year Treasury yield at 2 per cent or more.

But GIC's Mr Lim had said previously that while overheating concerns in the near term are valid, the situation is "not quite getting to" the Minsky moment - that is "still some way off".

The Minsky moment refers to a sudden, major collapse of asset values that marks the end of a cycle in credit markets or business activity.

Observers expect the Fed to remain dovish, as the Fed had indicated that it was prepared to overlook inflation overshooting its 2 per cent target because of the low base last year.

With inflation and interest rates set to rise, markets are unlikely to be too shaken if the rise is gradual. Such a dovish stance will support risk assets, with the abundance of liquidity also supportive of equity markets, said OCBC's Mr Menon.

Equities are still expected to outperform, so stay the course but stay diversified as markets remain volatile, he added.

• The Money Playbook is a new personal finance column that discusses how to take charge of your financial well-being. This is the seventh of an eight-part series.