Deficits, the Fed, and Rising Interest Rates: Implications for Bond Investors

Recent cash flows into bond mutual funds and exchange-traded funds have been very strong. A slightly higher percentage of bond cash flows has gone to short-term funds. This is fairly atypical for an environment of extremely low short-term yields.

One of the likely catalysts for this trend has been increased demand from money market investors in search of higher yields. With the Federal Reserve maintaining its federal funds rate target close to 0%, monetary policymakers have made it extremely difficult for many savers to generate sufficient income from their money market accounts. In this sense, savers unfortunately remain the “sacrificial lambs” of U.S. monetary policy as the Federal Reserve attempts to stimulate other segments of the economy.

Another probable influence is increasing concern among bond investors that mounting government debt levels will eventually drive up longer-term U.S. interest rates, which at present are below their historical averages (see Figure 1). In addition, the futures market expects the Federal Reserve to begin raising short-term rates before the end of 2010 as the U.S. recovery strengthens.

Figure 1. Historical, Current, and Implied Future Yields on the 10-Year Treasury Bond

Viewing these concerns together, some bond investors may hope that the total returns on shorter-duration funds will be relatively insulated in the event that both short- and long-term rates rise by the same amount (that is, a parallel upward shift in interest rates). In light of these uncertainties, it’s natural for bond investors to wonder whether they should act defensively by reshaping their fixed-income allocation with a narrow or “surgical” focus on mitigating risk. To provide better perspective and grounds for discussion, we begin by examining how the market expects interest rates to move and how various government bond indexes might perform if those expectations are met.

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