What the inverted yield curve means for your portfolio

As investors digest another 0.75 percentage point interest rate hike by the Federal Reserve, government bonds may be signaling distress in the markets.

Ahead of news from the Fed, the policy-sensitive 2-year Treasury yield climbed to 4.006% on Wednesday, the highest level since October 2007, and the benchmark 10-year Treasury reached 3.561% after hitting an 11-year high this week.

When shorter-term government bonds have higher yields than long-term bonds, which is known as yield curve inversions, it’s viewed as a warning sign for a future recession. And the closely-watched spread between the 2-year and 10-year Treasurys continues to be inverted.  

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“Higher bond yields are bad news for the stock market and its investors,” said certified financial planner Paul Winter, owner of Five Seasons Financial Planning in Salt Lake City.

Higher bond yields create more competition for funds that may otherwise go into the stock market, Winter said, and with higher Treasury yields used in the calculation to assess stocks, analysts may reduce future expected cash flows.

What’s more, it may be less attractive for companies to issue bonds for stock buybacks, a way for profitable companies to return cash to shareholders, Winter said.

Market interest rates and bond prices typically move in opposite directions, which means higher rates cause bond values to fall. There’s also an inverse relationship between bond prices and yields, which rise as bond values drop.

Fed rate hikes have somewhat contributed to higher bond yields, Winter said, with the impact varying across the Treasury yield curve. 

“The farther you move out on the yield curve and the more you go down in credit quality, the less Fed rate hikes affect interest rates,” he said.

That’s a big reason for the inverted yield curve this year, with 2-year yields rising more dramatically than 10-year or 30-year yields, he said.  

It’s a good time to revisit your portfolio’s diversification to see if changes are needed, such as realigning assets to match your risk tolerance, said Jon Ulin, a CFP and CEO of Ulin & Co. Wealth Management in Boca Raton, Florida.

On the bond side, advisors watch so-called duration, measuring bonds’ sensitivity to interest rate changes. Expressed in years, duration factors in the coupon, time to maturity and yield paid through the term. 

While clients welcome higher bond yields, Ulin suggests keeping durations short and minimizing exposure to long-term bonds as rates climb. “Duration risk may take a bite out of your savings over the next year regardless of the sector or credit quality,” he said.

Winter suggests tilting stock allocations toward “value and quality,” typically trading for less than the asset is worth, over growth stocks, that may be expected to provide above-average returns. Often, value investors are seeking undervalued companies expected to appreciate over time. 

“Above all, investors must remain disciplined and patient, as always, but more specifically if they believe rates will continue to rise,” he added.