Of Mutual Interest: Rising bond yields, growing questions

Higher bond yields are finally here, and investors have to consider what, if any, changes to make to their portfolios.

Short-term yields haven't been this high for almost a decade, and long-term yields have also risen. Investors expect rates to keep going up as the economy improves and as the Federal Reserve continues to raises rates above their historically low levels. At the same time, the Fed is letting its huge bond portfolio shrink.

Low bond yields are one of the key reasons stocks have climbed higher and higher in recent years, and it's possible the increase in yields will break stocks out of their pattern of steady gains. Higher bond yields may tempt investors who want income, and they also tend to slow down economic growth by making it more expensive to borrow money, which could be bad for stocks.

Jack Ablin, chief investment officer for BMO Capital Markets, said higher bond yields have been a long time coming, so investors might not need to make big adjustments just yet. But if yields climb further, Ablin's prepared to make big changes. Bonds could even become more appealing than stocks, which have started to look expensive.

Answers have been edited for clarity.

Q: How should investors react to the rise in yields? High-dividend stocks have already lagged the market, so should investors avoid them now?

A: There are a lot of investors who are income-oriented, so income is a key part of what they're trying to do. I'm not sure we'd necessarily say avoid income. But for the most part we've positioned for higher rates and we just haven't gotten them. So I haven't necessarily changed anything big picture. This rise we expected last year appears to be coming through nowadays. This is probably the longest anticipated bond bear market in history. Now it appears that while the Federal Reserve has curtailed its (easing) program, and many of the global central banks are doing the same.

Q: The rise in rates means the prices of many types of bonds are falling. Are any bonds doing well?

A: When Treasury yields rise, that tends to create a competition. You have to look at it asset class by asset class, but in general I would say more high-yield bonds should do well because they have higher coupons and shorter maturities. LIBOR-based floating rates loan should do well.

And rates are going up for a couple of reasons, including less buying from the central banks of Europe and Japan. But what's driving the reduced buying from the foreign central banks is better growth. It's that growth that's fueling demand for oil and natural gas.

Q: Most experts expect market volatility to rise this year because it can't stay at historic lows forever. Will that limit the gains for bonds?

A: Treasury yields decline as volatility increases because volatility then increases uncertainty, and in periods of uncertainty, investors tend to clamor for quality. If we see rates rise and volatility pick up, that could attenuate that rate rise or the impact of higher rates.

Q: How high are yields likely to go?

A: I'm not an economist, so I couldn't say. But historically, the yield of the 10-year note has tracked the gross domestic product, and nominal GDP is about 4 percent. So fair value for the 10-year is about 4 percent. That's where it should be, but that's where it should have been a year ago.

Yields need to rise about 150 basis points across the board for that to be fair value. If that happens, it's going to create problems for equities because then we'll have some competition. For now, the equity market is the only game in town because the bond yields are so meager. If the yield on the 10-year Treasury gets to 3.5 percent, then I'm selling equities. We have to be prepared for shifting our asset allocations around.

If rates rise enough, it's going to pull the rug out from under the stock market if the fundamentals don't improve enough.

Q: Since you're thinking about selling stocks and buying bonds if yields rise further, what do you expect stocks to do in the shorter term?

A: I think the stock market can be up high single digits or low double digits this year. While the tax plan may be priced in, I'm not sure the beneficial impact of those taxes is fully priced in. It's not just the repatriation of $2 trillion that could perhaps find its way into the equity market. We could see capital expenditures and business spending rise.

And countries including Germany and Japan view this tax rate as a shot across the bow. They're threatened by it. It's possible they could match our plans with similar plans and then we get a race to the bottom. The primary beneficiaries would be companies and shareholders.