Bond yields can rise for different reasons. The least popular one is if they rise because investors think the issuer faces solvency issues.
Bond yields keep climbing as the health prospects brighten and the economy gains traction. Higher rates due to better growth are exactly what central banks are after.
Investors avoid bond proxies in stocks, buy into financials and other cyclicals, and focus on credit risk in bonds. Growth stocks are not overvalued.
This is what happened to some of the highly geared shale-oil companies in the US during the commodity meltdown in 2016 and to European peripheral bonds during the euro crisis earlier in the last decade. But there is a far more encouraging reason why bond yields could go up: simply because economic prospects are brightening. For better growth means higher inflation, and higher inflation, in turn, means more risks to bond investors who do not benefit from the economic upside. They tend to get the coupons along the way plus the principal after expiration, but whether the economy is doing better or not does not increase their returns, while inflation threatens their purchasing power. Or to turn the argument around, bonds are an insurance against economic downside, and if economic prospects improve, the price of the insurance, i.e. the price of bonds, goes down.
This is exactly what central banks would like to keep seeing: rising bond yields as the economy does better. And the macroeconomic data has been stubbornly above expectations for more than six months now. This is due to governments pumping in money to support their economies but also to increasing hopes that the pandemic will be contained soon.
What to do?
As occurs every so often in life, the resolution of some problems raises other ones. For investors, this is about how to deal with higher rates. First of all, a fall in the price of insurance has left deep marks in most bond portfolios (see our ‘number of the week’). On top of that, the feel-good assets, such as the quality household names (let us call them bond proxies, as they show a remarkable earnings resilience even during recessions), are stalling as well. Investors will have to go out of their comfort zone and buy into financials and other cyclicals or raise their credit exposure. Alternatively, they could pile into super-growth franchises which are by no means overvalued at this stage.
What is going on in the markets? Julius Baer’s experts share their views.