The major risk across global markets is the fixed income sector.
It is noticeable how UK interest rates have remained static since early 2009, but bond yields have continued to fall and more recently rose once more.
The metric Macaulay’s duration measures the relationship between interest rate movements and bond prices. The resulting ‘duration’ number tells us how much a bond will rise in price if interest rates fall by 1 per cent and vice versa. The theory predicts that a duration of, say, 10 years means the bond price will fall by 10 per cent if interest rates rise by 1 per cent and vice versa.
However, in the UK and many other parts of the world, central bank interest rates are at their lowest levels in history. This has led to yield compression in bond markets to levels unheard of in the modern era.
In theory, interest rates could fall further; indeed, the Swiss, Danish and Swedish central banks have adopted negative interest rate policies, meaning savers are paying their banks to hold their money.
But, realistically, with developed market economies experiencing falling unemployment, wage growth, rising consumer demand and spending, the next likely move in interest rates is upward. As interest rates rise, bondholders are guaranteed to lose money.
Irrespective of interest rate movements, however, the markets have experienced significant volatility in bond valuations since the end of January 2015. If interest rates have remained static, what is driving such fluctuations?
Well, there are many factors to take into account: quantitative easing ending in the US and commencing in Japan and Europe, supply and demand, but perhaps speculation over when interest rates are likely to rise is the unrecognised driver.
The point is this: while yields are so compressed that they are unlikely to fall further, fixed income markets will remain susceptible to even a rumour that interest rates will rise earlier or later, affecting bond valuations.
Susceptibility to interest rate risk is not the only issue facing bond markets. The International Capital Markets Association conducted a poll of its members last year because of a belief among traders and market makers that “the secondary markets for European credit bonds have become critically impaired”.
Liquidity in bond markets has fallen by more than 70 per cent in some parts of the world, largely as a result of the unintended consequences of greater capital controls imposed by regulators.
Market makers (investment banks) used to be able to take on large tranches of bonds from sellers without having buyers. They would hold the bonds on their balance sheets and split them into smaller tranches to sell on at a margin.
Pre-financial crisis, there was often more than one buyer for every seller of bonds, meaning liquidity regularly exceeded 100 per cent. Now, such liquidity has shrunk, so a run on bonds as interest rates rise could spell disaster for the ‘low-risk investors’ for whom they are intended.
Traditionally bonds have represented the yang to the yin of equities. But right now, with the unequivocal risks in bond markets, what alternatives do we have for the lower-risk element of a portfolio?
Well, the view of analysts is that physical commercial property (but not real estate investment trusts), combined with a range of lower-risk alternative absolute return strategies, will suffice at this time.
Finally, let’s not forget cash. It may be delivering next to zero interest, but at least it will not make the losses that many investors are guaranteed to make on bonds.
Mark Woods is investment strategy officer at Fairstone Private Wealth
Macaulay’s duration
Developed in 1938 by economist Frederick Macaulay in his book The Movements of Interest Rates, Bond Yields and Stock Prices in the United States since 1856, this form of duration measures the number of years required to recover the true cost of a bond, considering the present value of all coupon and principal payments received in the future. Thus, it is the only type of duration to be quoted in ‘years’.
Source: California Debt and Investment Advisory Commission
