Volatility has ruled the stock market since the 2021 bull market ended at the start of 2022. Stocks made a nice run during the first half of 2023 but have turned down into correction territory since the end of July. The recent decline in stock prices is tied to rising yields in the bond market. Higher bond yields were not what market pundits predicted a few months ago.
In the debt markets, short-term interest rates are set by the Federal Reserve Board with its Fed funds rate.
But long-term interest rates don’t work that way. And that has huge implications for income investors…
Market forces determine long-term interest rates. Bond prices change to adjust the current yield. The 10-year Treasury acts as the benchmark for long-term rates. In practice, the Federal government issues Treasury Bills with four maturities, ranging from four to 52 weeks. Treasury Notes are sold with maturities of 2, 3, 5, 7, and 10 years. Treasury Bonds are issued with 20 and 30-year maturities.
With the Fed funds rate at 5.0% in early May, the 10-year Treasury was priced to yield 3.3%. As of October 4, the Fed Funds rate was just 0.25% higher, but the 10-year yield had climbed to 4.75%.
The market has realized that the Federal government will need to issue huge amounts of debt in the coming years. The White House forecasts budget deficits of at least $1.5 trillion for the next decade—or longer.
In addition, $7.6 trillion of U.S. government debt will mature next year and need to be refinanced.
All the new debt will be issued at much higher yields than the government has paid over the last decade. The government will be forced to pay higher, more attractive yields to place that much new debt into the market. Gone are the days when 10-year notes could be issued with 2% to 3% yields. I have seen forecasts for the 10-year yield to go as high as 7%.
As a result, even if the Fed cuts short-term rates next year, longer-term rates will likely be elevated.
Higher long-term interest rates make bond and bond fund investing a viable part of your investment strategy.
The Invesco BulletShares series of bond funds have the unique feature of holding bonds of a specified year until the bonds mature and pay off. For example, the Invesco BulletShares 2025 High Yield Corporate Bond ETF (BSJP) holds a portfolio of bonds maturing in 2025. In December of that year, fund shares may be redeemed for cash.
The fixed maturities allow investors to know how much an investment in each fund will return if held to redemption. The series of funds lets investors use a bond ladder strategy to react to changing interest rates. Invesco has a nifty bond ladder tool that enables you to see the potential returns. Here is a five-year ladder using the high-yield corporate bond ETFs.
The Yield to Maturity column shows the annual returns you will earn if you invested in the funds on the date I set up this ladder. You can see the YTM is an attractive 8.6%. The distribution rate is the yield of the dividends that will be paid. If you hold the funds until redeemed, you will get some share price appreciation to account for the rate differential. It is like buying an individual bond at a discount to the face value.Investing for income has changed dramatically over the last two years.
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