By Adam Baley                             

A few months ago, I wrote an article referring to the yield on the 10-year Treasury as the canary in the coal mine – something we all ought to watch. 

A client asked me recently, “Is the canary dead now that interest rates are up?” 

My response was, “The canary is still alive, but its song is a little bit softer.”

Rising interest rates irk bond investors because yields and bond prices move inversely.  As interest rates go up, the price of existing bonds goes down. Irksome as they may be, rising yields lately are not a signal to abandon bonds. Much has happened since that October article. Let’s review why rates have risen:

• A little confidence goes a long way. Much of the uncertainty lately has been focused on Europe’s ability to pay its debt.  Widespread austerity measures and a combined initiative from Europe to align tax receipts with spending have – for the moment – allowed worries to ease and confidence to return to the global bond market.  This renewed confidence has triggered investors’ departure from U.S. Treasuries, causing yields to rise.
• Safety isn’t as attractive as it once was. Two years ago, investors made an emotional decision to flee equities for the safety of CDs and Treasuries.  Today, both are just as safe, but earning 1% on a CD or 3.5% on a 10-Year Treasury bond isn’t as appealing when some profitable businesses are paying a 6% dividend.
• The economy is showing signs of strength. Pillars of economic growth – light vehicle sales, private inventories, housing starts and capital goods orders – are stabilizing and have shown signs of improvement.  As the economy gets healthier, higher interest rates are expected to help keep inflation under control.
• But – rates are not up because of inflation. One factor that may limit the rise in yields in the near term is the lack of inflation. For the most recent 12 months, the core Consumer Price Index, a primary inflation gauge, was up 0.8% – well below the Federal Reserve’s comfort zone of 1.6% to 2%. Moreover, leading economists don’t expect any meaningful increase in bank lending – a key contributor to inflation – for the next two years. That is a further indication that inflation may remain tame for some time.

It’s not all good news.

The recent extension of the Bush-era tax cuts will add $858 billion to the U.S. deficit over the next two years, and Washington does not plan to offset this cost with a reduction in spending.  Investors, as well as U.S. trading partners, can view rising deficits as ultimately leading to inflation.  Postponing the decision on tax rates to 2012 – an election year – only diminishes the likelihood that politicians can align taxes with spending.

Expect more turbulence ahead.  Europe isn’t out of the woods and neither are we.  Further uncertainty in Europe could cause investors to flee back into the safety of U.S. Treasuries. Here at home, our economy is improving, but it is still vulnerable to shocks.

Since October, the yield on the 10-year Treasury has risen roughly 1 percentage point – from 2.5% to about 3.5%. Despite that dramatic increase, we are still far below the 50-year average of 6.8% for the 10-Year Treasury – a historical reminder that rates have room to rise.

Rising rates are not a reason to abandon bonds.  However, they give a reason to shorten the duration on your bond ladder or bond funds. 

Investors need to be reminded that we own bonds for income and to reduce risk.  And you own bonds to give you the courage and confidence you need to be a stock investor.

Adam Baley is an associate at Landaas & Company and registered representative and registered paraplanner.

initially posted January 4, 2011

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