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Over the past few weeks, interest rates on U.S. Government bonds have risen sharply. From the beginning of September through the week ended October 5, the yield on the 10 Year U.S. Treasury bond increased from 2.86% to 3.23%, a 13% move. There is not one pinpoint cause for this move but rather a culmination of many factors including higher government budget deficits, a surge in U.S. Treasury issuance in order to finance tax cuts, the general unease regarding global trade and a slight uptick in inflation expectations, to name a few. It is important to keep in mind that, although rapid, these rate moves are within normal expectations for a transition year when the Federal Reserve moves away from accommodative interest rate policies.
Why are rising rates a concern? First and foremost, for fixed income investors, a rise in yields coincides with a decline in the principal value of existing bonds creating the potential for a negative total return. At Beacon Trust, we have been anticipating a rise in rates as the U.S. economy has accelerated, so we have been positioning portfolios to be more defensive by utilizing shorter maturity, high credit quality fixed income in order to withstand increasing rates. Shorter maturities and lower duration portfolios will protect against rising rates better than longer bonds that tend to have larger price declines when rates increase sharply. Bonds that are rated on the higher end of the credit quality spectrum ease concern of the ultimate repayment of the credit. A positive aspect of the new interest rate environment is that it allows us the opportunity to reinvest maturing proceeds into higher yielding issues. Beacon Trust’s conservative positioning of fixed income portfolios has been a major contributor to our fixed income outperformance relative to the Barclays Aggregate Index, a standard fixed income benchmark.
The rapid rise in rates also has some concerns for equity investors, as higher rates could lead to a slowdown in economic activity as the cost of financing becomes greater. We are not quite as concerned with this aspect as we continue to see a myriad of positives in the macroeconomic landscape. The United States economy continues to strengthen. Unemployment was just reported at 3.7%, the lowest levels since 1969, consumer confidence is at multi year highs, ISM surveys for both manufacturing and services continue to indicate expansion, and GDP growth exceeded 4% in the second quarter and for the third it is expected to be 3+%. Corporate earnings have been strong in 2018, with first and second quarter earnings growing in excess of 25% year over year. As the third quarter earnings season is about to unfold, we anticipate growth in excess of 20%, which provides us comfort in terms of equity valuations overall.
At Beacon Trust, we are constantly evaluating the financial market environment and looking for opportunities to add value into our client’s portfolios. We enjoy the opportunity to alleviate any concerns you may have regarding your financial needs. Please do not hesitate to contact a member of your team should you have questions!
Head of Fixed Income
Brian McGann, CFA
Executive Managing Director
Head of Investment Strategy