Rising Treasury Yields Make Short-Term Bonds Attractive

With yields near five-year highs, it’s a good time to shop for bonds. But experts say it’s best to stick to shorter-term securities.

The recent sell-off in the benchmark 10-year Treasury note pushed yields, which move in the opposite direction of prices, higher. While that has made risk-free Treasurys more attractive, other issues--from municipals to some types of commercial paper--also look more appealing.

Even with the recent rate increase, long-term rates remain at historically low levels. Since rates could inch higher, investors should look for issues that won’t lock them up for the long-term, experts say, especially when longer-dated securities aren’t paying much more in yield.

Staying in shorter-term issues also allow you to reinvest in higher-yielding debt should rates climb. Yields on the 10-year Treasury rose as high as 5.3% earlier this week, its highest level since April 2002, while yields on two-year Treasury notes were recently at 5.08%.

“The smart way to go would be to tippy-toe (into bonds) because it’s very difficult to tell at this juncture whether we’re going to be in a protracted bear market or if this is just a sell-off like we experienced this time last year,” said Marilyn Cohen, president of the Los Angeles-based Envision Capital Management, which manages bond portfolios for individual investors. "Shorter-term securities are a better bet because “you aren’t getting paid any incremental income to go out many years further.”

Munis Also Attractive

Yields on municipal bonds –- which work well in taxable accounts because they’re exempt from federal taxes and most state taxes -– have also recently climbed higher.

“People in the highest tax brackets should positively look at munis,” Cohen added. “At the end of last year, in order to earn 4% you would have to go out to 2020. Now, depending on what state you’re living in, all you have to do is go to 2014 or 2015. Those yields have gone up dramatically.”

However, investors will need about $50,000 to invest in each municipal bond, and at least $400,000 overall to achieve some measure of diversification, investing experts say.

There are several other fixed-income securities that benefit when rates rise.

Brant Keller and Ruth Forehand, financial planners at Financial Advisory Consultants in Naples, Fla., recommend seven-day commercial paper, a very short-term fixed-income instrument issued by top-notch corporations and banks, whose yields reset each week and rise in tandem with rates. While it requires a minimum investment of about $100,000, it’s a good place to park cash while waiting for a better opportunity.

“You might have someone that started at the beginning of the year with a yield of 4.8% and now they’re getting 5.25%, and there’s very little risk in that,” Keller said, adding that they tend to buy investment-grade rated companies.

Government Agency Debt

They also like Federal Home Loan Bank bonds -- a type of government-agency debt which tends to yield about 25 basis points more than Treasurys -– with maturities under two-years, Forehand added.

For investors with immediate cash needs – such as retirees – certificates of deposits and money-market funds are a good option; it also shields money from any short-term volatility in the bond market.

“The yields on CDs still outplace the yield on Treasurys,” said Greg McBride, financial analyst at Bankrate.com, a consumer finance website, adding that investors can find yields in excess of 5.4% across a spectrum of maturities from six months to five years. But you’ll have to shop around to secure the highest rates, he said.

For those who don’t have enough money to invest in bonds directly, mutual funds and exchange-traded funds that invest in shorter-dated securities might make sense, such as the iShares Lehman 1-3 Year Treasury Bond, which has an expense ratio of 0.15%.

For risk-averse investors that want to save on costs, Treasurys can be purchased directly though the Treasury Direct program. Securities, which are sold in $1,000 increments, must be purchased on auction dates, though investors can put in a request to buy securities and it will be executed automatically.

Time to Re-evaluate

The sell-off in bonds is also a good time to re-evaluate your risk tolerance and goals, as well as why you invested in bonds to begin with.

“The first thing you need to do is take a deep breath and remember that the decline in (the bond’s) value only hurts you if you need to get out today,” said John Nersesian, wealth strategist at Nuveen Investments. “If you can wait it out the paper loss is just that – on paper.”

And if you do need to get out, those losses can be used to offset capital gains logged in the stock market. “Then, you minimize the tax bite,” said Forehand.

But if you’re goals haven’t changed, stay put. “If your goals and risk tolerance haven’t changed over the past three weeks, neither should your investment strategy,” McBride concludes.