Sweeping repercussions of a rate rise

In spite of some concerns about the lack of value in sovereign bond, the 2.39 per cent yield on a 10-year US government bonds, as of July 2, is above the UK’s 2.06 per cent and significantly higher than those of many European countries, including Germany’s 0.84 per cent yield.

But with commentators suggesting September could see the first interest rate rise from the Fed, what affect could that have on bond yields in the US?

Nick Gartside, manager of the JPM Global Bond Opportunities fund, says that as the US approaches the beginning of policy normalisation, “there are naturally concerns about the reaction across bond markets – especially at current valuations”.

But he adds: “As long as the Fed is transparent and patient in raising rates, the economy and markets will be able to absorb the normalisation process. Not everything in the bond market offers value, but there are certainly some gems out there if investors are willing to roll up their sleeves and do the hard work to uncover them.”

The manager currently favours high yield – both in the US and in Europe – as corporate balance sheets look healthy and defaults are low.

He explains: “Companies are very practical in the way they’re managing their leverage, and credit spreads are pricing in a multiple of where default rates should be. While we often see a hiccup in high yield during the dog days of summer, US high yield spreads are 150 basis points wider than where they were this time last year, providing an attractive level of cushion.”

While the continuing Greece saga is a significant issue for fixed income investors, the US tightening of monetary policy is potentially more important for global markets.

Chris Iggo, chief investment officer, fixed income at Axa Investment Managers, explains: “The Fed sets the tone for pricing financial assets. A normalisation of US interest rates from the third quarter onwards – to say 2 per cent over the next year or so – will raise the average level of bond yields globally.

“Treasury yields will rise because a flat curve between the Fed Funds and 10-year bonds is not appropriate for the state of the US economy today. Yields of 3 per cent for longer-term bonds will be more appropriate. This creates some repricing of bond assets and could have an impact on credit spreads as well as government bond yields in other markets.”

That said, Bryn Jones, head of fixed income research at Rathbone Unit Trust Management, suggests the Treasury market is not pricing in a rate rise as aggressively as the Fed might think.

“If the Fed does deliver in September we might see a little squeeze in yields, as they start to price in possible future rises. I think that will have a knock-on effect on the gilt market.

“The gilt market might then start to believe the Bank of England will raise rates at some point and so that might mean that gilt yields rise,” he says.

He adds: “We think generally credit spreads will remain fairly stable because what you tend to find in the early part of a rate rise environment [is that] credit continues to perform quite well because people aren’t that worried [because] the reason they’re raising rates is the economy is doing better. The real worry is the peak in rates and that’s when we’d start to worry about credit and high yield.”

Of course any changes in monetary policy are likely to create different risks for investors.

Mr Iggo notes: “There are clear risks here. One is that inflation might accelerate further, pushing the Fed into more decisive action and leading to a more rapid adjustment in longer-term rates. The other risk is around how the markets will react. The Fed has not raised rates for nine years. There are people making trading and investment decisions that have never experienced a monetary tightening cycle.”

Joel Mittelman of The Boston Company Asset Management, part of BNY Mellon, adds: “We have seen fixed-income headwinds so far this year and would expect them to intensify, given rising rates, ongoing global sovereign risks, and the inevitable great rotation out of fixed income into equities.”

Nyree Stewart is features editor at Investment Adviser