The yield on the 10-year Treasury bond touched 1.94% on Friday, the highest level since last spring. This has a lot of investors asking once again: "Are we finally witnessing the long-awaited rise in rates?"
My answer: A qualified yes. While a normalizing U.S. economy should lead to higher interest rates in 2013, rates this year will likely rise slowly, erratically, and only back up to about the 2.25% level of last March. As I've mentioned before, I believe three factors are conspiring to keep any rate rise modest:
- Central Bank Buyers: In 2012, public sector institutions -- basically the Federal Reserve plus other large central banks -- absorbed much of the new supply of Treasuries, and they are likely to continue to be a significant source of demand this year. For instance, the Federal Reserve is still buying $45 billion in Treasuries monthly and central banks in both Japan and China are also still big buyers.
- Institutional Buyers: Demand for Treasuries also continues to come from pension funds, commercial banks, and those investors looking to hedge their liabilities. For example, commercial bank holdings of government securities are up roughly $500 billion over the past three-and-a-half years.
- Less Supply: While large deficits are still producing a significant supply of Treasuries, other sources of long-dated paper are drying up. As a result, there is actually less supply of long-dated bonds now than five years ago.
My colleague Matt Tucker mentions even more factors keeping a lid on rates in a recent article. Still, given how rate sensitive bonds are right now, even a small backup in yields could wipe out a year's worth of interest and impose some significant pain on bond holders.
As such, for investors with a time horizon of longer than one year, I continue to advocate an underweight to Treasuries. I instead prefer credit and municipal bonds, which are accessible through vehicles such as the iShares 10+ Year Credit Bond Fund (NYSEARCA:CLY), the iShares Investment Grade Corporate Bond Fund (NYSEARCA:LQD), and the iShares National AMT-Free Muni Bond Fund (NYSEARCA:MUB).
On the other hand, in light of the risks posed by the ongoing U.S. budget debates and the potential for soft U.S. growth in the first half of the year, investors with a shorter time horizon may still want to consider a benchmark weight to Treasuries.
Disclaimer: Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. A portion of MUB’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.