Bond Market Strategies for a Rising Rate Environment

by Annette Thau

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At the end of 2003, interest rates had fallen to historical lows. Virtually every pundit predicted that interest rates had nowhere to go but up, partly because existing levels were so low; but also because the Federal Reserve Bank (the Fed for short) was widely expected to raise rates. Since any rise in interest rates causes bond prices to fall, investors were advised to sell bonds.

By the spring of 2004, the predicted rise appeared to be on track. But instead of continuing to rise, the yield on the TreasuryÂ’s 10-year bond reversed course. Long-term bonds rallied and at the end of December, the yield of the 10-year Treasury remains around 4.2%, about what it was a year earlier before the Fed began raising rates. Rates on long-term bonds in other sectors of the bond market (municipals, for example) also rallied.

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As of this writing (mid-January), the consensus is that the Fed will continue to increase the federal funds rate (overnight rates on reserves traded between banks). If that turns out to be the case, other short-term rates (those on bonds maturing in two years or less) are bound to rise as well.

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