No matter what happens to the stock market this week after Friday’s 670-point drop in the Dow Jones industrial average and Monday’s sharply lower opening, higher bond yields are expected to remain a fixture in financial markets, which has implications for both stocks and bonds.

Long-term interest rates had already been moving steadily higher before the stock market rout on Friday, but after the Labor Department reported a better-than-expected jobs report Friday morning, the 10-year Treasury blew through 2.8% to end the session at 2.84%, its highest yield in more than four years.

The bond market, like the stock market, was spooked by a 2.9% year-over-year jump in average hourly wages — the biggest increase since April 2009 — which fueled fears of continued rising inflation and a more aggressive Federal Reserve.

“The run-up in bond yields is consistent with the economic data and prospects of both higher inflation and higher interest rates,” says Greg McBride, chief financial analyst at Bankrate.com.

Market strategists and economists are now more convinced than ever that the Fed will hike rates 25 basis points at its next policymaking meeting in March, and a growing number are expecting that three more hikes will follow this year, for a total of four hikes, although the consensus remains two more hikes after March.

A more aggressive Fed worries financial markets, especially if the reason for the monetary tightening is rising inflation. The resulting higher rates increase borrowing costs for companies, and rising prices increase their input costs while simultaneously reducing the purchasing power of consumers, which can ultimately slow demand and economic growth and impair earnings.

A more aggressive Fed also means that the easy money that helped boost stock prices for over eight years — through rate cuts and then asset purchases — is dissipating, fueling fears that the stock rally will end sooner rather than later and that bond yields are headed even higher.

“Generally, when central banks pull back on stimulus that ultimately is the catalyst  that brings growth to an end,” says Jeff Klingelhofer, a portfolio manager at Thornburg Investment Management. “The major story the next couple of years will be watching central banks.”

Also adding upward pressure on Treasury yields is an increase in supply. The Treasury announced last week that it would be adding $42 billion of new issuance over the coming quarter, including $1 billion each in upcoming 5-, 7-, 10- and 30-year bond auctions, and that can continue to grow as the deficit grows.

On the plus side, higher yields make bonds more competitive with stocks. One way to view the comparative value of bonds vs. stocks is to compare the earnings yield of the S&P 500, currently about 4.3%, against the 10-year Treasury yield. The difference currently is roughly 1.5 percentage point — the smallest spread in eight years — and traditionally the minimum to give stock investors comfort.

“When yields rise, that can take money out of the stock market,” says Leo Chen, a portfolio manager at Cumberland Advisors.

Rising bond yields, however, are a mixed bag for bond investors. They hurt bond prices but also provide more income to investors, who have been collecting low yields for years, many buying longer-maturity bonds and weaker credits in order to collect higher yields.

With yields now rising, bond investors should pay more attention to downside protection than upside capture, says Klingelhofer. “You’re not being paid to take risk, so paring down risk is what you should do at this stage of the game.”

He recommends that bond investors reduce duration, which measures the sensitivity of a bond’s price to changes in interest rates, and upgrade the credit quality of portfolios: “high quality bonds more focused on the front end of the yield curve.” 

“The cost to upgrade portfolios is very low,” says Klingelhofer. (The difference between two-year and 10-year Treasuries is roughly 70 basis points and between BB-rated and A-rate corporate bonds, about 140 basis points). “We’re happy to give up incremental yield to reduce potential volatility.”

He recommends more defensive corporate bonds, such as utilities, in both investment-grade and high-yield portfolios and in some cases, swapping out of high-quality corporates into Treasuries. Klingelhofer also favors floating-rate securities in the front end of the yield curve to protect against rising rates.

“In environment where risk is priced at the low end of historical spreads, that’s when it pays to be defensive.”

Todd Rosenbluth, director of ETF and mutual fund research at CFRA, also recommends shorter maturity investments: short-term high-yield ETFs from State Street (SJNK) or BlackRock’s iShares (SHYG), which hold securities with zero- to five-year maturities, and DoubleLine Low Duration Bond Fund (DLSNX), which takes a little more credit risk but less rate risk than the first two. 

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