Since the start of the global financial crisis in 2008, investors have flocked into bonds. Flows into bond funds have outpaced flows into equity funds in the last four of the past six calendar years, as is shown in Chart 1.
This is remarkable, as equity markets have more than recovered since 2008. The returns of the MSCI Europe have been positive in every calendar year since 2009, with the exception of 2011. Behavioural finance offers an explanation called “availability bias”, which explains how our thinking is strongly influenced by what is personally most relevant, recent or dramatic to us.
Clearly, 2008 has been lingering on the mind of investors. These large flows into government bond funds have resulted in very low yields, specifically in bonds from safe haven countries, such as the US, Germany and the UK. (There is an inverse relationship between bond prices and yields, so if demand for government bonds increases; prices of government bonds increase and yields go down).
To understand interest rates and bond yields better, we need to interpret the yield curve. A yield curve is a line that plots the interest rates of bonds with different maturities, but with equal credit quality at a fixed point in time. The shape of the yield curve therefore tells us what the market expects in terms of future interest rate changes and economic activity. Traditionally, central banks have controlled the short end of the yield curve with the policy rate (for example, the Federal Funds Rate set by the Federal Reserve in the US or the Bank Rate set by the Bank of England in the UK) while the market has determined the longer end of the yield curve, based on, for example, inflation expectations, GDP growth, supply and demand and risk appetite in the market.
Since 2008, however, central banks around the world have tried to exert influence on the longer end of the yield curve, by means of various so-called quantitative easing programmes. The Fed, for example, has made large-scale purchases of mortgage-backed securities, agency debt obligations and longer-term treasuries during three QE-periods from December 2008 until October 2014, in an effort to also keep longer-term government bond yields low. The Fed is now the largest holder of US government debt, owning roughly $4.2trn in assets, as of the end of December 2014.
Other factors that influence long-term rates are inflation expectations and GDP growth. Chart 2 shows the correlation between inflation (Core CPI) and 10-year Treasury rates in the US. The most striking examples to have affected inflation were the two oil crises in the 1970s (1973 and 1979). These events drove 10-year Treasury rates to 15.2 per cent in the beginning of the 1980s.
Chart 2.
Financial markets’ risk appetite is another factor that impacts long-term government bond rates. Chart 3 illustrates so-called risk-on and risk-off periods since 2008 and shows how 10-year Treasury bond yields changed over this period. Risk-on simply means that investors are willing to accept investments subject to higher volatility and risk-off implies the contrary. The chart shows that, when panic hits, investors tend to flock to assets that are considered safer or risk-free, such as government bonds. When this happens, demand and price increase and yields, therefore, decrease. When panic subsides, investors tend to exit those same assets, demand and price decrease and yields go back up.
Chart 3.
However, not all fixed income is the same, as you can see from the matrix in Chart 4. The matrix shows eight different fixed income sectors. When the financial crisis hit in 2008, interest rate-sensitive bond sectors, such as government bonds, performed better compared to other, credit-oriented bond sectors. When the recovery started in 2009, credit-oriented fixed income sectors, such as high-yield and convertible bonds, performed better.
Chart 4.
This leads us to the hypothesis that in times of recovery and, more specifically, in times of rising interest rates, the following three bond sectors will potentially perform best:
1. Credit-oriented strategies, for example high-yield bonds, as these bonds have a stronger correlation to the broader economic outlook and corporate earnings than interest-rate sensitive sectors.
2. Short duration strategies, such as floating-rate loans or bank loans, as these typically have lower interest rate sensitivity than longer-duration bonds and can capitalise on higher income from rising rates more quickly.
3. Global strategies, as these offer diversification through non-UK yield curves and currencies and seek to capitalise on differing business cycles and economic conditions around the world.
Franklin Templeton Academy tested this hypothesis using what was probably the most severe episode of rising interest rates in the US, from September 1993 until December 1994. During this period the Fed raised the Federal Funds Rate six times from 3 per cent to 5.5 per cent.
Longer-term treasury yields also rose over this period with five-year treasury yields rising 304 basis points (bps) (3.04 per cent) and 10-year treasury yields rising 245 bps (2.45 per cent). Chart 5 shows that, of eight fixed-income sectors, floating-rate loans (10.95 per cent), high-yield bonds (2.71 per cent) and global bonds (1.84 per cent) were the best performing fixed income sectors over that period. In conclusion, not all fixed income sectors are created equal. We identify credit-oriented strategies, short-duration and global strategies, as fixed-income sectors that have lower interest rate sensitivity than other fixed income sectors and hence would perform better in rising interest rate environments.
Chart 5.
Leo Niers is a training consultant at Franklin Templeton Academy
Key Points
Since the start of the global financial crisis in 2008, investors have flocked into bonds.
To understand interest rates and bond yields better, we need to interpret the yield curve.
Since 2008 central banks around the world have tried to exert influence on the longer end of the yield curve.
