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What the inverted yield curve means for your portfolio

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

Ahead of the Fed news, 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 rose to 3.561% after hitting an 11-year high this week.

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When short-term government bonds have higher yields than long-term bonds, known as yield curve inversions, this is seen as a harbinger of a future recession. And the much-watched spread between 2-year and 10-year Treasuries continues to reverse.

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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 might otherwise enter the stock market, Winter said, and with higher Treasury yields used in the calculation to value stocks, analysts could reduce cash flow. expected future.

Additionally, it may be less attractive for companies to issue bonds for share buybacks, a way for profitable companies to return cash to shareholders, Winter said.

How Federal Reserve rate hikes affect bond yields

Market interest rates and bond prices generally move in opposite directions, which means that higher rates cause bond values ​​to fall. There is also an inverse relationship between bond prices and yields, which rise as bond values ​​fall.

The Fed’s rate hikes helped push bond yields up somewhat, Winter said, with the impact varying across the Treasury yield curve.

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“The further out of the yield curve you go and the lower credit quality you go, the less Fed rate hikes affect interest rates,” he said.

This is one of the main reasons for the inverted yield curve this year, with 2-year yields rising more dramatically than 10- or 30-year yields, he said.

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

On the bond side, advisors monitor what’s called duration, measuring how sensitive bonds are to changes in interest rates. Expressed in years, the term takes into account the coupon, the term to maturity and the yield paid over the entire term.

Above all, investors need to remain disciplined and patient, as always, but especially if they believe rates will continue to rise.

Paul Winter

Owner of Five Seasons Financial Planning

While clients favor higher bond yields, Ulin suggests keeping durations short and minimizing exposure to long bonds as rates rise. “Duration risk can eat away at your savings over the next year, regardless of sector or credit quality,” he said.

Winter suggests steering stock allocations towards “value and quality”, typically trading for less than asset value, compared to growth stocks, which can be expected to provide above-average returns. Often, value investors look for undervalued companies that are expected to appreciate over time.

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

Mary Cashion

The author Mary Cashion