The bull and bear bronze statue stands outside the stock market, Deutsche Boerse AG, in Frankfurt, Germany.Michael Probst/The Associated Press
The 30-year bull market in bonds may be over, but that doesn't mean you should avoid the asset class.
For sure, the yields on U.S. government bonds have been on a spectacular tear in recent months, sending bond prices down and leading to a rotation out of bond funds and into equities.
And yes, bond yields are likely headed even higher from their current levels. The yield on the 10-year U.S. Treasury bond surged to a high of 3 per cent last month from just 1.6 per cent in May.
Eric Lascelles, chief economist at Royal Bank of Canada, believes that the most likely scenario is for the yield to move between 3 per cent and 3.5 per cent within the next 12 months, with a slim chance of rising as high as 4 per cent – as we move closer to interest-rate increases and bond sales by the Federal Reserve.
"New lows in yields are unlikely now that economic conditions are improving and the Fed appears to be changing course," he said in a note.
But far from worrying about the impact of rising yields on economic conditions, borrowing costs or the bond market itself, Mr. Lascelles is upbeat about the future. He argues that yields were unsustainably low before the Fed began to muse aloud about tapering its stimulative bond-buying program, known as quantitative easing or QE.
"The Fed's pivot, combined with normalizing economic conditions, served as a trigger to unwind some of the bond market's most egregious distortions," he said, pointing to negative real yields (or yields below zero after taking inflation into account) and a negative term premium (or paying extra for investing in a longer-dated bond, rather than the other way around)," he said.
Higher yields are going to shave off a little from U.S. gross domestic product growth, but he is reluctant to trim his economic growth forecasts because of the counterbalancing impact of a rising risk appetite and a diminishing fiscal drag from an improving U.S. budget balance.
He also sees an upside to the U.S. housing market, even as mortgage refinancings take a hit from rising borrowing costs: Home affordability is still attractive and construction activity has been conservative during the recovery so far, leaving plenty of room for further improvements in the sector.
At the same time, rising bond yields should benefit retired investors who rely upon fixed income, along with banks and insurance companies, whose profitability tends to rise with bond yields.
Of course, rising bond yields have at least one casualty: Bonds. As yields rise, prices fall and investors lose interest. But rather than steering clear of bonds, Mr. Lascelles recommends staying invested.
Generally speaking, bonds still offer a stabilizing mechanism for portfolios, often rising when equities fall. More specifically, falling bond prices are offset by rising bond coupons, or payouts.
"Bond investors who plan to stick around for the long term should actually celebrate the increase as they will benefit from the higher coupons for many years to come," Mr. Lascelles said.
David Berman