Rising rates and bond market volatility are creating select opportunities for income investors. Treasury yields were once again rising on Thursday, with the benchmark 10-year yield hitting levels not seen since 2007 and the 30-year Treasury touching highs not seen since 2004. Bond yields move inversely to prices. The former was last yielding 5.179% and the latter at 5.469%. Yields have been climbing as traders contend with the federal debt and deficit, higher oil prices and stubborn inflation, as well as the strength of the economy and the growing likelihood that the Federal Reserve will continue lifting rates. The central bank hiked its benchmark interest rate by a quarter percentage point last week and the market is now pricing in a roughly 70% chance it will do so again at its October meeting, according to the CME Group’s FedWatch tool . The move higher in yields is reasonable given the strong economic backdrop, said Rebecca Venter, senior fixed income client portfolio manager at Vanguard. “If you’re an investor coming to the market looking for income today, you’re in actually a much better position than you were if you had been doing so about a year ago, because your starting yield is much better,” Venter said. It is a much more balanced outlook for your future return potential, she added. “You can earn more income on a steady state basis. You will not see negative returns as quickly if rates were to continue to rise.” Avoid too much volatility The rockiness in the bond market is pronounced further out on the curve, which many experts caution investors to avoid. Long-dated bonds have greater duration, which is a measurement of the assets’ price sensitivity to interest rate moves. Shorter duration — anywhere up to about five years — is a good place for investors to focus if they don’t want to take significant interest rate risk, Venter said. Treasury bills are the safest since they are backed by the government, but taking a bit more credit risk in investment-grade corporates can give you a more substantial yield, she said. “It’s going to give you more durability of return and yield than a money market would, but you also won’t be taking on so much interest rate risk … if you’re fearful of rates continuing to rise,” she added. BSV YTD mountain Vanguard Short Duration Bond ETF year to date In addition to short-term investment-grade corporate bonds, floating-rate corporates in the one- to three-year space are also attractive right now, said Michael Arone, chief investment strategist at State Street Investment Management. While the bonds may have maturities of one to three years, the rates reset periodically. “Investors have been leaving fixed rate coupons for floating rate that adjust as yields move higher,” Arone said. “That is another attractive opportunity where I can get yields that are moving higher with very little interest rate risk and very little credit risk.” The State Street SPDR Bloomberg Investment Grade Floating Rate ETF (FLRN) , for instance, has a 30-day SEC yield of 4.02% and 0.15% expense ratio. Those willing to take on more credit risk can consider floating-rate bank loans. Those are considered below investment grade, but with yields north of 7% in some instances, investors now feel like they’re being compensated for the risk, Arone said. While floating-rate and short-duration instruments offer attractive yields with no or minimal interest-rate risk, investors can pick up some additional income by moving out slightly longer to intermediate-term bonds. They aren’t as volatile as longer-dated issues. For Omar Aguilar, CEO and chief investment officer at Schwab Asset Management, the “sweet spot” is in the five- to seven-year part of the curve. He favors investment-grade corporates right now. “Corporate fundamentals are very strong and balance sheets are still fairly solid across most sectors,” he said. Building positions incrementally Leslie Falconio, head of taxable fixed income strategy in UBS Americas’ chief investment office, also likes the five- to seven-year part of the curve for credit assets. Yet while yields are attractive and provide a nice cushion, she cautions against jumping all in. “A lot of this is knee-jerk reactions, and they have a tendency to reverse pretty quickly,” Falconio said. “Strong growth, a hawkish Fed is now priced into the market. The risk is the other way.” She recommends that investors build their positions incrementally. “These are not one or two or three day allocations,” Falconio added. “These are for longer-term horizons that you’re getting well above decade in high-quality income that I can compound, that offers me a very large cushion in terms of a potential … headwind if interest rates rise.” Within credit, she favors investment-grade corporate bonds and agency mortgage-backed securities. On the shorter end, she sticks with Treasurys and high-yield corporate bonds with an eye toward higher quality.
