Savers Nightmare: Why Short Rates Won’t Follow Bond Yields Higher

Bond yields are up. But if you can believe it: that just makes investing for income more difficult.

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The recent surge in bond yields has done nothing to lift the payout on bank CDs and other short-term investments. Meanwhile, long-term bonds and dividend-paying stocks grow riskier by the day. So it’s not getting any easier for retirees and other income-seeking investors, a group that has struggled for half a decade amid the stingiest yields in modern history.

This is a development not many saw coming so soon: bond yields spiking high enough to become attractive to income investors—but rising so fast that bond portfolios have suffered steep losses to principal. The backup in rates  has also let the air out of income-oriented stocks such as utilities and Real Estate Investment Trusts.

With further rate rises possible, such income-producing stalwarts now seem too risky for conservative investors. And there’s been no relief from the paltry payouts on investments that savers traditionally favor: bank CDs and money market accounts.

(MORE: Bond Markets to the Fed: We Don’t Believe You!)

The benchmark 10-year Treasury bond yield has soared to 2.5% from just 1.6% in May, reaching its highest level in nearly two years. Yields on corporate and municipal bonds have followed suit. Yet the average 12-month CD yield is just .24%, same as in May, and for the ninth consecutive week the average money market account yield is just .11%.

Behind all of this is the Fed’s stated intention to begin tapering its massive bond-buying program, which has been holding long-term rates artificially low for years. Short-term rates, which the Fed directly controls, are not responding because the Fed is probably two years away from boosting its key short-term Fed Funds rate.

At a mid-year briefing last week, Peter Fisher, Senior Director of the BlackRock Investment Institute, said he expects long rates to stabilize at current levels for the rest of the year, which would make the suddenly higher yields attractive. But the risk remains that rates will rise further (and bond portfolios fall), he said, as we are experiencing an unwinding of the stampede into bonds over the past five years.

Dividend-paying stocks and other classic defensive shares that have been in favor as bond substitutes look especially dicey, BlackRock believes. By the firm’s valuation model, these shares are the most expensive they’ve been in 35 years.

The equity-income play is not dead, Fisher says. There is and will remain a strong appetite for anything with a decent yield. But investors must realize utilities, REITs, telecoms and other stocks with a yield “are an income play with equity volatility,” Fisher says. “If you lose sight of that you’re going to be disappointed.”

What BlackRock really likes, and which makes less sense for income seekers, are stocks hinged to stronger growth—energy, manufacturing and technology. The firm also favors emerging markets stocks, which trade at a 33% discount to developed world shares and on that basis are the cheapest they’ve been since 2008.

(MORE: Ben Bernanke to Markets: Chill Out!)

Where does all this leave income investors? Sadly, with even fewer choices than has been the case since the financial crisis. Bond yields are up, but buying now risks losses to principal in coming months. Stock dividends were a reliable income alternative for the last few years, but the shares now look vulnerable. Meanwhile, bank CDs and money market accounts haven’t improved one iota.

So lean towards short-term bonds and CDs and things that carry a floating rate with an eye toward reinvesting at higher yields a little later. Don’t give up entirely on long-term bonds and dividend stocks. Diversification is always smart and these will do alright if the market has misread the tealeaves and rates stabilize or fall a bit from here.

“While portions of the equity dividend space look expensive, there are pockets of value,” says Russ Koesterich, Global Chief Investment Strategist at BlackRock, noting that the economy-sensitive stocks he likes most (energy and manufacturing) pay dividends. So do some non-U.S. stocks hinged to stronger growth.