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One of my colleagues in sales told me recently that he’d heard the same message from several clients in the recent past: “I don’t know what to do in fixed income, but as long as it’s not losing money I’m happy”.
For a few years now, investors in bonds have feared a rise in bond yields and the resulting loss of capital. Having enjoyed a 30-year bull market fuelled by collapsing inflation, the nearing of the cessation of “ultra-loose” monetary policy was always likely to bring this to an end. Indeed, US Treasury yields have been gradually rising ever since the US Federal Reserve’s (Fed) announcement that quantitative easing was to cease, and much more rapidly once its balance sheet started shrinking in 2018.
For now, there are undoubted risks in bond markets, but there are also a number of opportunities. The Fed and the UK’s Monetary Policy Committee have begun tightening policy in advance of the potential inflationary impacts of cross-border trade tariffs and Brexit, so higher bond yields seem entirely appropriate for this stage of the cycle. While it is unlikely that yields are due for a massive spike higher from here, further risks to the upside certainly do exist.
During the last few years of the bond bull run, yields and risk premiums (spreads) fell simultaneously, driven in part by quantitative easing. Massive bond buying programmes have forced investors down the quality curve, meaning most asset classes have delivered some excellent returns since the global financial crisis. In the UK, for instance, the gilt market is up almost 55% in total return terms since March 2009. Over the same period, investment grade is up 120%, and European high yield an impressive 235%!
If lower yields and tighter spreads were driven by these policies, then the corresponding risk is that as these policies cease and are reversed we will see a nightmare of rising yields and widening spreads. I think that the more obvious repercussion is a material increase in volatility across all markets. Despite the undoubted lower levels of demand from central banks, traditional buyers of fixed income assets have been keeping their powder dry waiting for higher yields and should provide some support to some areas of the bond market. As yields rise, pension funds, life insurers and private investors all naturally become more attracted to bonds.
As yields rise, pension funds, life insurers and private investors all naturally become more attracted to bonds.Many investors have to hold some bonds in their portfolios and are now concerned about losses caused by a rise in yields, widening spreads or even higher default rates as we reach the end of the credit cycle. For these investors, finding the right areas of the bond market is the key. Being able to select from the wide range of bond assets provides some protection and the ability to maintain the required bond exposure. As always, the outcomes from government, corporates, emerging markets and high yield bonds are likely to be very different.
Typically, when they are worried about rising yields, bond investors reduce duration. This is because the impact of rising yields on long-dated bonds is greater than short-dated bonds. While the starting yield may be low, so too are the downside risks to capital. Taking this a step further, we could look to move from fixed to floating rate notes, which would remove the sensitivity to higher yields.
Another way to reduce interest rate sensitivity is to move from interest rate-sensitive assets to more credit-sensitive areas such as high yield bonds. The further down the credit spectrum, the more dominant the credit risk premium (spread) becomes and the lower the correlation to government bond yields. Taking such action will reduce interest rate risk for sure - but it will also increase exposure to credit risk. Such an approach may be appropriate for now as credit spreads are reasonably attractive and continue to over-compensate for expected defaults. That said, as we move towards the end of the credit cycle there is greater risk of a downturn and increased volatility – at some point, complacency will most likely be heavily punished.
It feels like a tough time in bonds, again. In summary, investors should look to limit their interest rate exposure down and stay diversified. If possible, adding global capability would also help, as different economies at different stages of their economic cycles, and different valuations, bring opportunities to protect capital. At a fund level, mandates with the greatest flexibility are likely to see the best outcomes in this environment.