Investment involves risk and there will be times when investors face difficult choices. There are some who think that one of those times is now.
Interest rates are rising, putting at risk the capital value of bond allocations.
Following a 0.25 per cent rise in the Federal Reserve target rate in December, the consensus on the US is for two or three further increases this year, probably of the same magnitude.
In the UK the timetable is less certain. In the wake of the surprise vote on Brexit, the Bank of England cut rates and expanded its quantitative easing programme. Continued political uncertainty is likely to delay a reversal of monetary policy, but the economy has continued to grow while higher oil prices and a sharp fall in sterling have pushed up inflation.
What should investors do? There are several options, some better than others. As so often in investment, the key is not to over-react. Reminding ourselves of why we have bonds in the first place is a good idea. In my view, it is to provide regular income and reduce overall portfolio risk, and that in itself should be a warning on responses that increase portfolio risk.
One such course of action might be to move down the credit spectrum. Default rates are currently at reasonably low levels and investors can pick up an immediate improvement in yield by moving out of investment grade bonds and into high-yield, either lower rated corporate bonds or emerging markets. These types of bonds will be less sensitive to rising interest rates as their returns are determined mainly by credit risk.
The downside of switching to lower credit ratings can be that it increases the overall risk level of a balanced portfolio. In terms of risk, lower credit bonds behave more like equities than like higher rated bonds. Over the period 1995-2015, for example, high yield and emerging markets bonds had a correlation to equities of about 65 per cent. The correlation of global investment grade bonds to equities, by contrast, was -5 per cent .
Another option might be to adjust the duration of a portfolio’s bond allocation. Short duration bonds have more yield volatility, but due to their lower interest rate sensitivity, they tend to have lower price moves. Longer duration bonds tends to be more anchored, but smaller moves in the yield have much greater impact.
When rates are set to rise it seems a simple, logical response to dampen interest rate risk by shortening duration. But again, there can be hidden consequences even in such an apparently obvious move. Issues to consider include covariance, which measures how different asset classes interact with each other. Shortening the duration of a bond allocation is likely to mean giving up yield, but the impact on overall portfolio volatility is uncertain.
Any of these strategies implies confidence in the ability of active managers to outperform the broader market. It may seem ‘obvious’ that rates are rising and that an active response is the right course, but investors need to be careful not to give away outperformance in fees.
There are significant benefits, though, for investors who hold to a strategic, long-term allocation to bonds.
Let’s go back to our original point about revisiting why we are investing in bonds in the first place. Small, slow-paced increases in interest rates will have relatively limited impact on capital values, while total returns will be restored as cashflows are re-invested at higher returns. Over time, higher yields will further restore a key traditional characteristic of a bond allocation, which is to provide an income component in a balanced portfolio.
A globally diversified fixed income allocation helps mitigate the effects of rising interest rates in the US and the UK. Monetary conditions worldwide remain diverse. Key regions such as Japan and the euro area are still very much in the phase of suppressing interest rates to sustain prices and economic activity. History suggests (though not always a guide to the future), that in times when sterling rates are rising, a global portfolio is likely to remain positive.
Sterling investors fearing negative interest rates in international markets should take account of exchange rates, which provide an adjustment mechanism for balancing out varying rates of interest. Over time, on a hedged portfolio, fluctuations in the exchange rate are likely to make up the difference between sterling yields and yields in other markets.
Finally, but perhaps most importantly, bonds offer a diversification from equities that it is extremely difficult, if not impossible, to replicate through other asset classes. Investment grade and risk-free bonds offer highly liquid markets with predictable cashflows. Their volatility and cyclical characteristics tend to have a negative correlation to equities that can be invaluable in times of stress.
We may be tempted to discount the safety net offered by bonds when things are good and prospects look positive. But then, if we knew the future investment would carry no risk – and bring no reward.
Paul Malloy is head of fixed income of Vanguard Europe
Key points
The consensus on the US is for two or three increases in interest rates this year.
One such course of action might be to move down the credit spectrum.
A globally diversified fixed income allocation helps to mitigate the effects of rising interest rates.
