Higher Yields – Bond Investors Should Proceed with Caution

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We have seen a crazy market so far this year.  Stocks have been in rally mode since January and they are just now starting to show signs of fatigue.  Bonds have dropped in recent weeks, which has given yields a boost.  Many market pundits say that this shows that a steepening of the yield curve may occur.  When the yield curve steepens, that means that the duration of mortgage assets is longer and short term rates get a bump as well.

To illustrate my point, 10 Year Treasuries had a yield of 1.8% a month ago.  That same 10 Year Note is now yielding 2.3%.  Pundits and analysts say this is a great market for regional banks.  Regional banks have a lot of mortgage securitieson their balance sheets, which makes them attractive investments as yields rise.  The best way to play the broad field of regional banks is the SPDR KBW Regional Banking (ETF) (NYSEARCA:KRE) .

This positive environment combined with good expected earnings should boost the financial sector into rally mode.  This comes as a great surprise for financials who have largely been underperforming the broad market the past few years.

The only uncertainty is to see whether this rise in yields is a short term phenomenon or a beginning of a trend.  I am inclined to believe it is a trend because we have been hearing since the beginning of the year that bond yields are expected to rise.  Pimco’s Bill Gross came out numerous times and told us to brace for higher bond yields over the next few months.  Sure enough, here we are with the higher yields.  Of course, nothing is certain in the market so we will need to wait and confirm that this move is a trend before placing money down.

Martin Roberge, director of the portfolio strategy incubator at Canaccord Genuity, believes this is the beginning of a trend.  Mr. Roberge believes we are looking at 3.5% yield on the 10 Year Treasury in 12-18 months.  That is a pretty bold prediction but I don’t believe it will be far off. Although, no one can predict interest rate or treasury forecasts, with any degree of certainty.

Rising yields is not all about making money, there is potential of losing a good amount of your holdings if they are a longer duration.  I recommend you looking at your holding to see the duration of assets.  PIMCO Total Return Instl’s (MUTF:PPTRX) duration for instance is 5.68 years, which has fallen since the beginning of the year.  That is good and Pimco should easily be able to capitalize of the rising yields.  Another important factor to consider is that the volatility that comes along with higher yields may help some banks over others.  For example, Goldman Sachs (GS) is a huge bond trader and they should benefit greatly from any volatility experienced.

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