Fixed income investors must pay the piper

July 12, 2017

After almost a decade of record low interest rates, central bank tightening spells trouble for bond investors. Alex Dryden, global market strategist at JPMorgan Asset Management, looks at how investors can offset any losses.

Since the collapse of Lehman Brothers, the world’s top 50 central banks have cut interest rates over 700 times between them. That is approximately one interest rate cut every three trading days.

Central bankers haven’t stopped there in a coordinated monetary policy stimulus attempt to coax life out of the sickly global economy. They’ve also driven up their combined balance sheet value to $24.7 trillion, equivalent to more than half the global government bond market.

After nearly a decade, growth is beginning to pick-up across all major regions. The synchronized upswing in international economies has seen global equities rally by 14.7 per cent since October 2016. But with a healthier diagnosis for the global economy, central bankers are beginning to wean the patient off the ultra-loose monetary policy medicine.

This will lead to some nasty side-effects for fixed income investors who have enjoyed strong returns on the back unprecedented levels of support.

As the central bank rhetoric started to turn last week, early signs of withdrawal symptoms began to kick-in. German 10-year bunds jumped 0.23 per cent and the US 10-year Treasury rose 0.22 per cent in the space of just five trading days. Tiny moves in absolute terms, but more than enough repricing to wake up the markets to a new outlook.

Changing attitudes at the central banks

The queue forming up to engineer tighter monetary policy conditions looks like a concerted shift in tone. The US Federal Reserve has already raised interest rates twice this year and will raise rates once more in 2017. The rate hiking cycle should continue in 2018 with an additional three to four rate hikes. And Fed officials have already signalled they will begin reducing the balance sheet starting later on this year – an unprecedented step that will drive up yields.

The European Central Bank is likely to begin tapering their asset purchase program starting in January 2018. Markets are also pricing in a 60 per cent chance of an interest rate hike in the next twelve months.

In the UK, hawkish comments from a number of Bank of England officials have seen markets pricing in a 57 per cent chance of an interest rate hike by the end of 2017.

Making matters worse, tighter monetary policy is coming at a time when the average duration of global bond indices sits at a record high of seven years, versus a long-run average of 5.3 years. The high levels of duration mean that bond prices, which move inversely to interest rates, are going to be highly sensitivity to changes in the underlying monetary policy environment.

Investors can mitigate any losses

From these rock-bottom levels, even small moves out in rates at the long-end will wipe out annual returns, so it won’t take much of a back-up to inflict outsized losses. Rising rates will bring capital destruction to fixed coupon bond holders who are heedless of interest rate risk. But the danger of owning debt at these levels is manageable.

Firstly, investors can maintain flexibility in their duration exposure. Longer-dated government bonds with higher levels of duration will get hurt the most by rising rates. Look for shelter in shorter duration.

Secondly, diversify into higher yielding areas of the bond market where interest income hasn’t been so beaten down by zero interest rate policies. Sectors like high yield debt and investment grade corporate bonds typically have lower levels of duration than their government, a characteristic that helps provide a degree of buffer against rising rates.

These sectors also pay out a higher coupon, which helps offset some of the losses incurred from falling bond prices during a rate hiking cycle.

Finally, bond investors need more international diversification. Driven by home bias, investors too often tend to stay close to home in their fixed income portfolios. The average US investor has 95 per cent of their fixed income allocation in US bonds, yet the US debt markets make up only a third of the global bond market.

Overreliance on domestic exposure leaves investors missing out on the diversification benefits present in sectors such as emerging market debt, which can help cushion the blow of rising interest rates. 
While there are steps investors can take today to help protect their portfolios from the side-effects of tighter monetary policy, the immediate outlook for the asset class is challenging.

Quantitative easing was designed to boost asset prices today at the sacrifice of future returns. It would appear for fixed investors that the time has come to pay the piper.

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