It’s one thing to say that interest rates will eventually go up, and it’s something entirely different to see them actually start to rise. Over the last couple of weeks the stock and bond markets have been spooked as the benchmark 10-year treasury has seen its yield spike. Since May 1st, the 10-year yield is up 100 basis points, from 1.6% to 2.6%. In percentage terms, that is a huge move, which is why the markets have been rattled.
It is also a fairly uncommon situation to find the stock and bond markets falling at the same time, as equity outflows typically are redirected into bonds as a safe haven. However, the rise in stocks in recent memory has largely been helped by falling bond yields (which make equities more attractive on a relative basis), so it makes sense that when bonds start to sell-off, causing rates to rise, that it would also cause a retracement in recent equity gains. So, we have bonds and stocks dropping simultaneously, and in many cases, bonds actually falling more than stocks, which hardly ever happens.
So what do we do as long-term investors? First, let’s keep things in perspective. Rather than simply focus on your stock and bond returns in May and June, consider them in the context of the last several years. While we are finally having a market correction, it should have been expected (though the exact timing is always hard to gauge). Healthy markets need to pull back every once in a while to avoid overheating. This time is no different. In fact, it had been a record number of trading days since we last had a 5% correction, so we should not fret too much at the market’s recent action.
With yield-sensitive securities leading the way down, should we throw in the towel and pronounce income-investing and the dividend-paying stock bull market dead? I would not be so quick to judge. Does a stock yielding 4% or 5% look a bit less attractive if bonds yield 2-3% instead of 1-2%? Sure. Does that mean the merits of owning high-yielding stocks have simply vanished? Hardly. Many MLPs and REITs are seeing their yields jump to 6-7% again. Even if interest rates rose another percentage point, those securities will remain attractive in the big picture.
I would suggest making a shopping list of your favorite stocks and bonds. At a certain price they become very attractive and are likely ripe for purchase during this correction. Many reached fair value, or even surpassed it a bit, thanks to interest rates hitting record lows. That was bound to stop at some point, and now the market is re-calibrating its expectations that rates will not stay ultra-low forever. We may have already known that, but markets don’t typically react until the move higher begins. And investors can expect that market prices will adjust to even higher rates ahead of time, since the financial markets are discounting mechanisms. In fact, we are likely seeing that process play out right now.