Recent financial headlines have focussed on the timing of the US Federal Reserve ‘tapering’ its purchases of long-dated US bonds. A consequence of any tapering - rising US interest rates - continues to raise it head.
The rising interest rate topic first made headlines in the US in 2010, and then again in 2011 and 2012, but only in 2013 have we seen the first sustained increase in long bond yields. For some investors, rising interest rates are a good thing, with potential for increased returns on the billions of dollars holed up in cash and short term deposits, whilst for holders of long-dated bonds, rising interest rates may be cause for concern.
Interest rates and bond prices
Bond prices and interest rates usually move in opposite directions. This means that when interest rates rise, bond prices tend to fall, and vice versa. For example, if you pay $100 for a bond with a face value of $100 paying a 5% coupon, and interest rates then rise to 6% for the same maturity, the value of your bond will fall in price to equate to 6% yield to maturity.
For the past 30 years, developed market bonds - represented in bond indices by the United States, Japan and the core Euro region which make up over 90% of traditional bond indices - have had the tailwind of falling interest rates, delivering capital gains in addition to regular income. However, with long bond rates only a little above their 30 year lows, the future expected return from long term bonds is more cautious.
But opportunities to make money in bonds still exist. Notably, one of the major changes to bond markets over the past 30 years, and especially in the last 10 years, is the significant increase in the supply of bonds from a wide variety of new issuers, including Emerging Market countries, and companies the world over.
This broadening of bond markets provides opportunities to diversify bond portfolios by investing in economies and companies not linked solely to the economic fortunes of developed markets. This is a good thing, given the limited appeal of investing in developed country bonds, where real interest rates (nominal interest rates less inflation) currently provide little, or even a negative return to bond holders.
These low rates are a deliberate policy, with Quantitative Easing (QE) initiated by the US Federal Reserve to support the US economy, and designed to exert downward influence on bond rates. The theory is that lower long term rates make companies more willing to borrow to invest and expand their businesses, resulting in economic expansion and increasing employment. The QE policy has been implemented by ‘printing’ US dollars which has also had the added benefit of lowering the US dollar.
So far our discussion has focussed mainly on government bonds, but it’s important to note that not all fixed income is created equal. Some securities are more sensitive to interest rate movements than others, and some deliver strong performance in a rising interest rate environment.
Reducing interest rate sensitivity
The following fixed income strategies tend to have lower interest rate sensitivity:
- Credit-oriented strategies, and in particular, non-investment grade sectors such as high yield corporate bonds and corporate bank loans tend to be more correlated to the overall economic outlook and corporate earnings than interest rates. Improved balance sheets and liquidity, healthier credit ratios and increased credit availability may reduce the impact of rising interest rates.
- Short-duration strategies such as short term bonds and floating rate bank loans have lower sensitivity to rates than their longer duration counterparts, and they can capitalise on the higher income from rising rates more quickly.
- Global fixed income strategies offer diversification through exposure to bonds and currencies which seek to capitalise on differing business cycles and economic conditions around the world. In some cases they offer not only higher yields, but also the potential for currency appreciation.
There are many different countries, yield curves, and currencies to invest in. Importantly, in the current environment, seeking strategies that can diversify away from traditional bond benchmarks, such as the Barclays Global Aggregate Benchmark, in which the most indebted nations (and potentially those will less ability to repay) of the US, Japan and core Euro region dominate, will be critical to minimise the risk of losses, and achieve positive returns for investors as global rates continue to rise.
Bonds continue to provide significant diversification benefits for investors, and in most cases offer negative correlation to equities. This reduces portfolio volatility and provides the shock absorber for portfolios in times of economic and equity market stress. These positive characteristics should not be forgotten even though the bond investing environment is more challenging looking forward.
Jim McKay is Director of Advisory Services at Franklin Templeton Investments.