What Higher Rates Mean for Your Portfolio
Quick Take
Stocks have reached new highs while bond yields have risen to some of their most attractive levels in years, reflecting a mix of Federal Reserve policy, heavy government and corporate borrowing, and shifting global capital flows.
Higher rates create challenges, but they also improve the income and long-term return potential of high-quality bonds.
For investors whose stock allocations have moved above target, today’s stronger bond yields create a timely opportunity to rebalance and restore portfolio discipline.
The stock market has climbed to new highs after several periods of uncertainty this year. The gains have also been broader than some of the technology-led rallies of recent years, with strong results across a number of industries.
Despite some volatility at the end of August, the S&P 500 is up roughly 13% for the year. Global stocks, measured by the MSCI All Country World Index, have gained about 14%.
At the same time, another important development has been taking place in the bond market. Long-term interest rates have moved higher, with the 10-year Treasury recently around 4.8% and the 30-year Treasury above 5.2%. For bond investors, these are some of the most attractive yields available in many years.
So why are interest rates still this high?
The Fed Is Still Part of the Story
Markets continue to reassess the outlook for Federal Reserve policy.
In his recent Jackson Hole speech, Fed Chair Kevin Warsh made clear that the Fed's 2% inflation target remains firm and that policymakers are prepared to respond if inflation does not continue to improve.
That has pushed investors to reconsider the assumption that lower short-term rates are just around the corner.
Longer-term rates reflect more than Federal Reserve policy, but expectations for inflation and future short-term rates still matter. If investors believe rates may need to remain higher for longer, they will generally demand higher yields on longer-term bonds as well.
More Borrowers Competing for Capital
There is also simply more demand for capital.
The U.S. national debt recently exceeded $40 trillion for the first time, reflecting years in which federal spending has exceeded tax revenues. Large deficits mean the Treasury must continually issue substantial amounts of new debt, and investors may demand higher yields as they absorb that supply.
The federal government is not the only borrower. The enormous buildout of artificial-intelligence infrastructure requires capital for data centers, power generation, semiconductors and related projects. Whatever the ultimate payoff from that investment, today it means more borrowers competing for capital.
Higher Rates Are a Global Story
Interest rates are rising outside the United States as well.
For decades, Japanese interest rates were extraordinarily low, encouraging Japanese institutions and investors to purchase bonds elsewhere in the world.
That is beginning to change. The Bank of Japan has gradually moved away from its ultra-low-rate policies, and Japanese government bond yields have risen sharply. The 10-year Japanese government bond recently approached 3%, its highest level in decades.
As Japanese bonds become more attractive to domestic investors, less Japanese capital may flow into U.S. Treasuries and other overseas markets. That matters because interest rates are set in a global market, not just by what happens in Washington.
What Does This Mean for Investors?
The $40 trillion national debt understandably attracts headlines, and the country's longer-term fiscal trajectory deserves attention.
But we would be careful about viewing any particular debt milestone as a tipping point.
Bond yields move for many reasons: inflation expectations, Federal Reserve policy, government borrowing, global capital flows and expectations for economic growth.
Interest rates do not rise only because something is going wrong. Rates can rise because investors are worried about inflation or government borrowing. But they can also rise because the economy is growing, businesses are investing and demand for capital is strong.
Today's market appears to reflect some combination of all of these forces. The rapid investment surrounding artificial intelligence is one example. Business investment has been growing quickly, and a significant portion of that increase appears tied to AI-related capital spending.
Stronger economic growth can push real interest rates—interest rates after accounting for inflation—higher. That can create pressure for some assets in the short run, but stronger growth can also support corporate earnings.
So higher rates are not automatically bad news for stocks. For bond investors, the story is more straightforward.
Yield Matters
For bonds, starting yield matters a great deal.
Over time, the yield available when a high-quality bond is purchased has historically been an important driver of the return an investor ultimately earns.
During much of the period following the 2008 financial crisis, bond investors faced an uncomfortable choice: accept very low yields or take considerably more credit and interest-rate risk in pursuit of additional income.
Today, the situation is different. Treasury securities and high-quality corporate and municipal bonds offer yields that would have been difficult to find for much of the past two decades.
Higher rates can cause existing bond prices to decline, as investors have experienced recently. But those same higher yields increase the income portfolios earn and improve the prospective returns available from newly purchased bonds.
For investors drawing income from their portfolios, that is especially meaningful. Bonds can once again generate substantial income without requiring investors to reach as far for risk.
A Good Time to Revisit Portfolio Balance
There is another practical implication of today's markets.
After strong stock returns over the past several years, some portfolios have naturally moved above their long-term targets for equities. Normally, rebalancing means selling an asset that has performed well and adding to one that has lagged. That discipline can be difficult in the moment.
Today's bond market makes the decision somewhat easier. Reducing an overweight position in stocks does not mean making a prediction that the stock market is about to decline. It simply means bringing the portfolio back toward the level of risk originally intended.
And unlike much of the past decade, the proceeds can now be invested in high-quality bonds offering meaningful yields. For investors whose stock allocations have moved above target, that combination creates a reasonable opportunity to rebalance.
Keeping Perspective
Higher interest rates come with tradeoffs.They raise borrowing costs and can create volatility in both stocks and bonds.
But there is another side to higher rates. Investors are once again being paid meaningful income for owning high-quality bonds.
That matters at a time when stocks have also produced strong gains. Investors whose equity allocations have moved above their targets can rebalance without moving into an asset class offering very little in return, as was often the case during the years of near-zero interest rates.
We do not know whether stocks or bonds will produce the better return over the next year. Fortunately, long-term investors do not need to make that prediction. The more important task is to maintain an appropriate balance between growth, income and risk.
With stocks near record levels and bond yields at their most attractive levels in years, today's market offers a good opportunity to do exactly that.
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