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Putting rising bond yields in perspective

After receiving a few questions in response to yesterday's bond-related post, I thought it might be helpful to offer some additional thoughts here today.

There's quite a bit we can learn from recent activity in the bond market, so let's start there with a few specifics.

Over the past three months, the 10-year Treasury yield has gone up by 1%, from 2.65% on November 10 to 3.66% yesterday. That's a very significant rise in a short period of time.

Bond Investing 101 (as summarized in our current article, The Bond Basics You Need to Know in 2011) tells us that when bond yields rise, their prices fall. This is indeed what we've seen. The degree of the price decline depends primarily on the length of the bond. The longer the maturity, the greater the price decline.

We can see this clearly in the returns of various bond funds over the past three months. Vanguard's Intermediate-Term Bond Index fund has lost -5.73% over the past three months, while the company's Short-Term Bond Index is down just -1.56%. (This is a vivid illustration why we encouraged our readers to shorten their bond maturities in anticipation of rising interest rates.)

What about TIPS? TIPS are "inflation-protected" bonds that are supposed to adjust to keep up with inflation. But this doesn't mean that they can't go down in value. There are two basic forces at work with TIPS.

First, they do in fact respond to increases in CPI-measured inflation, helping their owners maintain their purchasing power in inflationary times. Unfortunately, the second force is old fashioned supply and demand. As investors see higher interest rates coming (or think they do, at least), TIPS are subject to the same selling pressure as regular bonds. So while TIPS help insure bond portfolios against rising inflation, they're still subject to swings in interest rates.

Back to the overall bond landscape. The 1% rise in rates over the past three months is quite steep. It's not typical for bonds to move that far, that fast. At this recent pace, the 10-year Treasury bond would be yielding 7.65% a year from now, up from 3.66% today. I'm not aware of anyone who expects that to be the case.

In fact, it's important to recognize that while the higher yields of the past three months have bond investors spooked, the 10-year Treasury note has almost exactly the same yield now as it did one year ago!

On February 9, 2010, the yield was 3.67%. Yesterday, it was 3.66% (see chart at left). So this recent rise in interest rates has simply offset the significant drop that occurred as investors poured money into bond funds last year.

The main takeaway is not to get overly worked up about short-term changes in bond yields (and by extension, losses in bond funds). We don't want to be blind to the larger trends, which is why we have suggested shifting bond money to the short-end of the yield spectrum. But these swings in interest rates happen, and usually they don't signify a whole lot.

Further, all it would likely take to reverse the upward move in bond yields is for Europe to announce a new round of trouble. That, or a dozen other catalysts, could easily prompt investors who've been cautiously pulling their money out of bonds and putting it into stocks to reverse course, sending bond yields lower again.

In contrast, if you're following SMI's approach and investing based on a long-term, personalized investing plan, you don't need to sweat every little blip in your bond returns (just as you shouldn't sweat every little blip in your stock returns). Hopefully this helps explain how you can keep an eye on some of these trends without becoming overly concerned about them.

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