Bond Investors should not Jump Ship as Interest Rates Rise

Since late 2008 and in the midst of the last financial crisis, the U.S. Federal Reserve (FED) has used bond purchases or quantitative easing (QE) to reduce long-term interest rates. The move was intended to instil market confidence and encourage spending and investments, which in turn affect demand for labour, and for goods and services. In the summer of 2013, the U.S. Federal Reserve hinted that it will start reducing its asset purchase program. Investors’ reaction was pretty dramatic, with the bond market being hit the hardest. Equities had a temporary sell-off but long-term sovereign bond yields soared - bond prices declined - and credit assets followed suit.

Only in December 2015 did the FED make its first positive interest rate move, following a seven-year period where the benchmark rate remained flat at 0.25 per cent. Fast forward to last week, when the Federal Open Market Committee met on September 26, 2018 and raised rates for the eighth time in less than three years, to bring the interest rate on excess reserves to 2.5 per cent. By no means did this move take market by surprise, and expectations are for more interest rate hikes in the months ahead.

As we enter the last quarter of the year, it is fair to say that so far global bond investors’valuations have experienced a relatively negative performance. Expectations of increasing inflation in most developed nations and higher interest rates are generally negative for bond portfolios. However, one needs to differentiate between the types of bonds held in the portfolio. Even though the term ‘bond’ is used in a generic way, it is incorrect to say that all bond types will be impacted similarly as interest rates rise further, both in the U.S. and elsewhere.

We can group fixed-income assets in two main groups, namely rate-sensitive assets and credit assets. The former refers to high-quality sovereign bonds which generally have a low probability of default, and hence low credit risk. But on the other hand, these are highly sensitive to changes in interest rates. High-quality sovereign bonds will perform well in a falling interest rate environment but they tend to perform less well in a rising interest rate environment. It holds true that market participants do not wait for central banks to announce their next rate move. It is investors’ expectations which drive markets before the direction and magnitude of the interest rate change are made public.

Local investors can easily associate themselves with this, given the impressive gains recorded on local sovereign bonds when the market had expected interest rates in the Euro area to fall and to remain low in the long-term, as inflation was nowhere to be seen. Conversely, as economic data in the single currency improved and global growth gained ground, investors’ expectations changed and yields on local sovereign bonds picked up and bond prices declined. This notwithstanding that the European Central Bank has kept interest rates in negative territory.

On the flip side, credit assets refer to bonds which tend to be less rate-sensitive but have a higher probability of default. Hence the higher income yields compared to high-quality sovereigns. This asset class includes investment grade corporate bonds, high yield corporate bonds and emerging market debt, among others. Generally, credit assets perform well when the economy is in better shape and vice versa. Highly-rated investment grade corporate bonds share similar characteristics to high-quality sovereign debt, and therefore these two types of bonds tend to be highly correlated. High yield and emerging markets debt are less correlated to sovereign debt.

It is common for investors to believe that in a rising interest rate environment all fixed income assets generate poor results. However, various research shows that historically, during rising rates environments, high yield and emerging market debt generated superior returns to safer alternatives such as U.S. Treasuries and U.S. investment grade bonds. The opposite also holds true, that is when rates declined, safer assets outperformed because of their duration.

Investors have to keep in mind their investment objective and the purpose they had opted for a particular bond investment or portfolio of bonds. During a rising interest rate environment, an investor who is aware of how different fixed income segments behave, can adjust his portfolio to reflect a higher allocation towards credit assets, in order to reduce portfolio sensitivity to changes in interest rates. However, the investor should only adjust the portfolio if his risk tolerance allows the price volatility of riskier assets.

Short-term headwinds should not change the important role which a portfolio’s bond allocation plays. If the risk of your overall portfolio meets your risk tolerance, and your overall portfolio meets your investment objective, you can probably ignore concerns brought about by a rising interest rate environment. However, if you have been a bond investor for long, this time round you should start looking into other assets to diversify further your portfolio.

Following years of easy monetary policy, it seems major central banks are closer than ever to reaching one of their main objectives of QE – economic growth. Inevitably interest rates in other parts of the world, including Europe, will eventually increase as has already happened in the U.S. With this in mind, in a rising interest rate environment, bond investors should not jump ship but consider a more flexible and diversified asset allocation.

 

This article was prepared by Gabriel Mansueto, Branch Manager and Senior Investment Advisor at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email gabriel.mansueto@jesmondmizzi.com

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