The Fed has awakened bond yields - and that's not such a bad thing Having trawled the ocean's deepest trenches for several years, interest rates have suddenly regained buoyancy, with the U.S. 10-year Treasury bond yield bubbling more than 100 basis points higher since May. Canadian yields are up almost as much. This movement has delivered a painful case of the bends to fixed-income investors, leaving them wondering whether more is in store, how the economy will be affected and how to position their investment portfolios. The catalyst for higher yields came from the U.S. Federal Reserve, which announced over the summer that it would soon begin tapering its bond-buying program. But a mystery remains; by itself, this should have warranted a mere 11-basis-point increase in yields. A basis point is one-hundredth of a percentage point. What explains the rest? The key lies in acknowledging the Fed's comments for their vast implications: The world's bellwether central bank is shifting from delivering stimulus to removing it. Markets have rationally responded by extrapolating that the fateful day of the Fed's first rate hike has also probably neared, as has the (distant) date when its ponderous balance sheet begins shrinking. This tangle of factors collectively justifies another 35-basis-point increase. The simple passage of time over the past five months chips in a further 16 basis points. And with the economy and Fed both normalizing, then why not bond yields? Real yields (i.e. adjusted for inflation) have responded by escaping from the purgatory of negative rates, and a rising term premium nears the same milestone. This wave of normalization justifies the remainder of the move. These higher rates should dull U.S. GDP growth by up to 0.3 per cent a year - a material but not recessionary hit. Given international spillovers, the global effect is similar. Rate-sensitive sectors such as housing absorb the brunt of the impact. Fortunately, U.S. housing should remain buoyant because it remains undervalued and underbuilt. On the other hand, Canadian housing is more vulnerable. Of course, higher rates are not entirely charmless: Long-suffering savers will benefit, and economic efficiency may even improve as marginal investments dependent on cheap credit are pruned. It is one thing for yields to soar, as they have. It is something very different for them to sustain that increase. Most of the big bond market selloffs of the past 20 years proved unsustainable. In contrast, this one can probably stick, and even make further gains over time. First, the simple passage of time must not be underestimated. Fed tapering and rate hikes inch closer each day, and the anticipatory effect alone should add a further 55 basis points to the U.S. 10-year bond yield over the next year. This is a powerful current. Second, real rates are no longer negative, but they are still fairly low. Improving risk appetite and economic growth should continue to nudge them gradually higher. Third, the term premium is still slightly negative. Perversely, this means that investors are being punished for taking on the extra uncertainty associated with longer-dated bonds. As extreme distortions in demand (Fed buying and risk aversion) fade, the term premium should turn positive. But the upward migration of yields need not be outsized or particularly brisk. For all of the Fed's buying, it has financed just 21 per cent of the Treasury's needs over the past five years. As rates rise, interest-rate-sensitive participants such as financial institutions, households and pension funds should helpfully fill the coming void. Every basis point increase in yields theoretically unlocks a colossal $33-billion in new money. It is tempting to point to the high U.S. public debt load as further justification for rising yields, especially as the government shutdown and debt ceiling brew. But the relationship is notoriously loose, and arguably invalidated altogether by the U.S. dollar's status as a reserve currency. Meanwhile, several factors should limit any increase in yields. Deteriorating demographics constrain economic growth and tilt investor preferences toward bonds. Widespread ratings downgrades have placed a premium on the few remaining "risk-free" investments. And policy makers may be tempted to subtly repress interest rates to cushion high public debt loads. How should investors feel about a further moderate increase in yields? They need to start by recognizing how lucky they were over the past three decades. Bond yields migrated from record highs to record lows, generating outsized capital gains along the way. Absent this tailwind - and with a potential new headwind in the form of rising rates - future returns cannot possibly compare. For now, investors should probably remain underweight their normal targeted exposure to bonds. But they shouldn't shun them altogether. Bonds helpfully stabilize a portfolio's returns, and duration, barbell and credit strategies can insulate against rising rates. In fact, bond investors who plan to stick around for the long run may even learn to love rising yields: The initial capital loss will eventually be trumped by a lifetime of juicier coupons. Eric Lascelles is chief economist at RBC Global Asset Management.