One of my colleagues in sales told me recently he had heard the same message from several clients in the recent past: “I don’t know what to do in fixed income; as long as it’s not losing money I’m happy”.
For a few years now investors in bonds have feared a rise in bond yields and the resulting loss of capital.
Having enjoyed a 30-year bull market fuelled by collapsing inflation and the hunt for that mix of yield and duration, the nearing of the end of “ultra-loose” monetary policies was always likely to see the end of this long bond yield reset.
Indeed, US treasury yields have been gradually rising ever since the Federal Reserve’s announcement that quantitative easing was to cease and much more rapidly once its balance sheet started shrinking in 2018.
For now, there are undoubted risks in bond markets, but in my view there are also a number of opportunities.
The Fed and the Monetary Policy Committee in the UK have begun tightening policy in advance of the potential inflationary impacts of cross-border trade tariffs and Brexit, so higher bond yields seem entirely appropriate for this stage of the cycle.
While I do not believe yields are due for a massive spike higher from here, further risks to the upside certainly do exist.
During the past few years of the bonds bull run, yields and risk premiums (spreads) fell simultaneously, driven in part by quantitative easing.
Massive bond buying programmes have forced investors down the quality curve and meant that most asset classes have delivered some excellent returns since the global financial crisis. In the UK for instance, since March 2009, the gilt market is up almost 55 per cent in total return terms, investment grade is up 120 per cent, and European high yield 235 per cent.
If lower yields and tighter spreads were driven by these policies, then the risk is that as these policies cease and are reversed we see a nightmare of rising yields and widening spreads. I think this outcome is unlikely, largely because, despite the lower levels of demand from central banks, traditional buyers of fixed income assets have been keeping their powder dry waiting for higher yields.
As yields rise, pension funds, life insurance and private investors all naturally become more attracted to bonds.
Many investors have to hold some bonds in their portfolios and are now concerned about losses caused by a back-up in yields, widening spreads or even higher default rates as we reach the end of the credit cycle.
For these investors, finding the right areas of the bond market is the key. Being able to select from the wide range of bond assets provides some protection and the ability to maintain required bond exposure.
Typically, when worried about rising yields, bond investors reduce duration – the impact of rising yields on long-dated bonds is greater than short-dated bonds. While the starting yield may be low, so too are the downside risks to capital.
Taking this a step further, we could look to move from fixed to floating rate notes, which would remove the sensitivity to higher yields.
Another way to reduce interest rate sensitivity is to move from interest rate sensitive assets to more credit sensitive areas, such as high-yield bonds.
Taking such action will reduce interest rate risk for sure, but will increase exposure to credit risk. That said, as we move towards the end of the credit cycle there is greater risk of a downturn and increased volatility – at some point, complacency will most likely be heavily punished.
It feels like a tough time in bonds, again.
In summary, I would look to keep my interest rate exposure down and stay diversified.
Roger Webb is head of pan-European credit of Aberdeen Standard Investments
