Bond ETFs: Should you yield to rising rates now?

This may not be the time to throw in the towel.

By Minyanville.com Aug 28, 2013 2:48PM
 (© Digital Vision/Digital Vision Ltd.)Everyone has experienced a moment when you are driving and see a yield sign that makes you think twice before proceeding with caution. While you don't necessarily have to stop completely, the sign is giving you a warning that you may need to make a judgment call on whether or not it's safe to continue on your intended course. If there is a big truck barreling down on you, it may be a good idea to steer clear before you get run over.

Fixed income investors have likely felt like deer in the headlights this year as rising interest rates have trained them in their sights like a big 18-wheeler with its foot on the gas. Those that have had their portfolios allocated to long-duration Treasuries, municipal bonds, or emerging market bonds have felt the most pain.

Those that have made strategic allocation shifts away from long-duration bonds and into shorter duration securities in the high yield and senior loan sectors have likely weathered the storm with fewer price fluctuations.

Many economists and market forecasters are divided on the future of interest rates as they try to divine the response to September tapering and unemployment trends, as well as other domestic data. Recently the CBOE 10-Year Treasury Note Yield (TNX) hit a new year-to-date high of 2.9%, which is close to the nice even 3% that many experts are eyeing. Since that high, interest rates have fallen slightly as investors have sought shelter from the wobbly stock market.
Bill Gross and Jeffrey Gundlach, the two reigning bond kings, believe that the majority of the move in interest rates has likely been made. They have both been vocal about the economic stability wavering if bond yields continue to rise. However, that hasn't done much to ease the tide of fixed-income investors running for the hills and selling their bond funds in favor of stocks or cash over the last four months.

So the question becomes -- have yields reached their peak or are they just pausing before they resume another leg higher?

I am starting to see some indications that are pointing toward stability in interest rates based on a variety of factors:

1. Interest rates have risen dramatically since their April low and may have already priced in a September taper along with the weak hands being shaken out of the bond market.
 
2. Fears over looming conflict in Syria have investors flocking to bonds as a safe haven when stocks are falling. This has reinstated the traditional "flight to quality" in asset flows that take over when global uncertainty emerges.

3. It was recently reported that the spread between two-year and 10-year Treasury yields has widened to 2.55 percentage points, which is rapidly approaching the historical high of 2.93 points. The yield curve has steepened dramatically and will likely slow down or flatten if economic data does not support higher interest rates.

If you are still holding onto fixed income positions, I believe it's important to analyze your portfolio with a level head. You should be evaluating your holdings based on their duration, credit quality, fees, sector exposure, and manager expertise. Any positions that have underperformed their peers should be monitored closely and ejected from your portfolio by using rallies to your advantage.

I would not consider eliminating all of your bond exposure at this time, based on the potential for a fall in interest rates that will support higher bond prices. We have already seen strengthening off the lows in the iShares 20+ Year Treasury Bond ETF (TLT), iShares MBS ETF (MBB), and iShares Investment Grade Corporate Bond ETF (LQD). If stocks continue to falter, we may see additional money coming back into these bond sectors for at least a short-term bounce. The key moving forward will be to actively size your fixed income exposure to your risk tolerance and expectations for interest rate volatility.

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