2 Factors Keeping a Lid on Interest Rates

by on April 1, 2013 | ETFs Mentioned:

Despite talk of an imminent sharp rise in interest rates, the yield on the 10-year Treasury note is back below 2%. This is more evidence that the much vaunted “Great Rotation” out of bonds has yet to occur. (Otherwise, bond prices would have fallen and yields would have gone up.)

The great rotation was always more myth than reality. In fact, the fuel for the equity rally has been coming out of cash, not out of bonds being sold. We had more evidence of that last week. Fund flows for the week ending March 20th were up another $2.6 billion for stocks, a slowdown from previous weeks, while bond flows were substantially higher, up $3.7 billion on the week, according to BlackRock data.

Normally, when the economy is improving – even if the pace is relatively slow – that environment should support interest rates rising. But right now there are two important structural factors supporting bond prices:


The Fed is continuing its asset purchase program. First, and most importantly, the Fed is likely to continue its current pace of asset purchases at least through mid-year. Furthermore, as indicated in the Fed’s latest statement, even it does decide to pull back, this is likely to happen via a reduction of bond purchases, rather than a cessation of the program.

A dearth of new supply of bonds. In addition, however, the other factor supporting bonds is the fact that supply is relatively low. With the private sector deleveraging, overall net new issuance is down substantially from pre-crisis levels.

With the Fed buying a good portion of the new issuance, there is simply not a lot of new supply for the market to absorb, and investors are still hungry for yield.

The bottom line is, while I expect rates to continue to rise, I would stick with a year-end target of 2.25-2.50% for the 10 year Treasury note. But the backup in yield is likely to be a slow affair, with a lot of backing and filling.

In short, I still believe that with duration or rate sensitivity at historic highs, investors should avoid the long-end of the Treasury curve and instead accept marginally more credit risk, with a focus on high yield, bank loans, and emerging market debt. These can be accessed through the iShares iBoxx $ High Yield Corporate Bond Fund (HYG), the iShares Floating Rate Note Fund (FLOT), and either the iShares J.P. Morgan USD Emerging Markets Bond Fund (EMB) or the iShares Emerging Markets Local Currency Bond Fund (LEMB).

Source: BlackRock, Bloomberg

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.

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. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.

International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.