16th October 2013 at 1:17pm
Typically, as interest rates rise, bond prices fall. A simple concept, but fundamental to fixed income investing.
Typically, as interest rates rise, bond prices fall.
In recent years, however, it is not something that bond investors have lost too much sleep over. With borrowing costs having been anchored at historic lows for close to five years and the yields on core government bonds kept in check by central bank bond buying, the interest rate backdrop has been a relatively benign one.
Until very recently, investors believed that this would remain the case for some time – received wisdom suggested rates would be held at current levels until at least 2015. Little wonder then that bonds have enjoyed a number of years of strong returns. However, events over the summer have challenged this consensus and prompted speculation that rates will rise earlier than expected. The prospect of the Federal Reserve scaling back its bond purchases, a process more commonly known as tapering, has made investors anxious that a crucial support for bond markets is soon to disappear. Furthermore, as evidence continues to point to a gradual recovery taking hold in the global economy, investors now fear that present borrowing costs are unsustainable (despite central bank assurances to the contrary). Bond markets have moved to reflect these changes in perception, with both US and UK government bonds experiencing a sharp sell off.
All this poses a fundamental challenge for investors. If we are entering an era of sustained interest rate rises, and if rising rates typically lead to falling bond prices, then investors must explore strategies that mitigate the negative impact on their fixed income exposure. For those seeking a truly diversified portfolio, simply exiting bonds completely is not an option; fixed income remains an integral asset class in the diversification process. In the short term, while the world economy may be healing, it is far from fixed and continued recovery is not a given. The defensive qualities of bonds will be a welcome addition to any portfolio when markets hit the inevitable bumps in the road.
A better solution to the problem of rising rates is to more effectively manage the duration of a portfolio’s fixed income exposure. Duration is a measure of a bond’s sensitivity to changes in interest rates: the longer a bond’s duration the more it is affected by a change in rates.
The longer a bond’s duration the more it is affected by a change in interest rates.
If we remember that bond prices normally fall as interest rates rise, then bonds with a shorter duration should outperform longer duration bonds in a period of rising rates. Therefore, while not being completely free from the harmful effects of rising rates, shorter duration bonds can help lessen the impact.
Within MyFolio, we hold around half of our fixed income exposure in short duration bond funds, provided by a variety of investment managers and across both active and passive strategies. If bonds are to suffer a sustained period of interest rate-driven underperformance, then these should provide valuable insulation from some of the worst effects. The funds we currently hold also reflect our preference for corporate bonds over government debt. Rising borrowing costs will have a negative impact on the absolute yields of more interest rate sensitive parts of the corporate bond market. However, a gradually improving economic backdrop will be beneficial for the credit profiles of most companies. This should allow corporate bonds to outperform sovereign bonds on a relative basis.
From a wider multi-asset perspective, a turn in the bond market may not necessarily be a welcome development but nor should it elicit excessive anxiety from those invested in a well-diversified, actively rebalanced portfolio. If an improving economic backdrop is the driver of rising interest rates and bond yields, then this should be good news for growth-oriented assets such as equities. Consequently, positive equity performance should more than compensate for weakness in bond markets.