InvestmentsSep 1 2022

How interest rates affect bond prices

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Pimco
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Supported by
Pimco
How interest rates affect bond prices
(Liza Summer via Pexels)

In the UK, data tables from the likes of Moneyfacts and Savings Champion have been updated to reflect slightly higher interest rates being put onto savings accounts, cash Isas and one-year bonds.

Conversely, mortgage holders will be tightening their belts as debt becomes more expensive.

But what does all of this mean for the fixed income landscape? Do different parts of the bond market react differently to changes in central bank interest rate rises?

And how can bond fund managers help protect clients' capital in a high inflation, higher-interest-rate world.

General effect on bonds

Bond prices are inversely correlated with interest rates, meaning that when interest rates go up, bond prices go down and when interest rates go down, bond prices go up (see below). 

According to digital asset manager Collidr, £298bn has been wiped off the value of UK corporate bonds since the start of 2022.

It blames this predominantly on soaring inflation – caused by events such as the war in Ukraine, global supply constraints and rising energy prices – which has prompted central bank action to raise rates as a combative measure.

Persistently below-target inflation can trigger a loosening of monetary policy.Pimco spokesperson

In July, the consumer price index rose to 10.1 per cent, from 9.4 per cent in June, with a predicted peak of up to 15 per cent predicted for early 2023.

The Bank of England has responded by hiking the base rate.

In August, the BBR hit 1.75 per cent with further rises expected.

Relationship between rates and prices

Pimco Market Intelligence Series chart

 

 

But how do rising inflation and reactionary interest rate rises impact bond prices? 

Moneybox's Brian Byrnes, head of personal finance, puts it simply: "Inflation expectations are generally negative for bonds, as when inflation is rising, central banks tend to raise interest rates to try and control inflation.

"Higher interest rates make the fixed return or coupon of bonds become less appealing to investors. In order for the bond to become more attractive to investors in this situation, the price has to fall to make it a more competitive investment."

This is why many managers advocate maintaining a constant allocation to inflation-hedging assets, as these can help investors cushion their portfolios against unexpected spikes.

A spokesperson for Pimco states: "By contrast, signs of decelerating inflation can push bond yields lower.

"Persistently below-target inflation can trigger a loosening of monetary policy, including a lowering of interest rates, with the aim of encouraging borrowing and spurring growth."

Why do bond prices fall when rates rise?

A bond’s price always moves in the opposite direction of its yield.

To understand this critical feature of the bond market is to recognise that a bond’s price reflects the value of the income that it provides through its regular interest payments, which are fixed.

When interest rates are rising, new bonds will pay investors higher interest rates than old ones, so old bonds tend to drop in price.

Falling interest rates mean that older bonds are paying higher interest rates than new bonds, and therefore, older bonds see their prices rise.

Exploiting price inefficiencies

According to a Pimco spokesperson, when recession risks are higher, "you want to be very cautious about credit-sensitive investments", although the spokesperson says current conditions are quite positive.

"The big challenge is that we have an inflation problem, so you have policymakers tightening when growth is already relatively low. Plus, it has been a long time since there has been a recession without massive policy support," the spokesperson adds.

"A lot of people invested heavily in credit-related assets over the last decade because they felt they needed to generate incremental return."

Different durations

Duration is used to estimate how sensitive a particular bond’s price is to interest rate movements.

Pimco's representative says: "While duration is not the same as a bond’s maturity date, it is true that bonds with long maturities are generally more sensitive to interest rate movements, while bonds with shorter maturities are less sensitive.

"This is ultimately because investors in longer-maturity bonds will not be repaid their principal for some time, so they have an increased risk exposure; whereas holders of shorter-maturity bonds will get their principal back sooner so have less long-term risk."

One reason high-yield bonds often have relatively low duration is they are typically issued with terms of 10 years or less and are often callable after four or five years.

Generally, high-yield bond prices are more sensitive to the economic outlook and corporate earnings than day-to-day fluctuations in interest rates.

Value of diversification

Because there are parts of the bond market that are more sensitive to rate movements than others, diversification becomes key.

Bonds with a longer time to maturity are more sensitive to rate rises than short-dated bonds, as the negative impact of the rate rise on the bond coupon has longer to be felt.

Byrnes explains: "A long-term bond may have 30 coupon payments left, which will be negatively impacted by a rate rise, whereas a shorter-term bond may only have a couple of coupon payments left."

But despite the near-term uncertainty in bond markets, managers have said they are finding opportunities in fixed income – not just in investment grade (AAA-BBB rated bonds) but also in higher yield (BBB- and below). 

High yield opportunities

Capital Group investment director Flavio Carpenzano says HY bonds have performed better than "most other" areas of the fixed income market during the recent sell-off. 

"The shorter duration of the high-yield market means it is less sensitive to the higher interest rates that we are experiencing alongside higher inflation and monetary policy normalisation," he explains.

"The historical correlation of high-yield bonds with interest rates has been relatively low as high yield has tended to be driven more by credit risk than interest rate risk."

It's hard to time an entry point perfectly, but we are becoming more constructive about interest rate levels.Pimco spokesperson

He says the team has a "conservative stance" in its portfolios. "To put things into perspective, global high-yield corporate bond spreads recently widened to around 550-600 basis points, but that liquidity is generally not a concern 

"In the past, at the peak of a recessionary period, spreads for high-yield corporate bonds have typically been around 1,000 bps."

He says recession is not "a certainty" at this point, or that it will be sharp or long-lasting.  

Resilience

Much depends on whether central banks can get inflation under control, but managers say there are many actions an investor can take to mitigate that risk.

Fahad Kamal, chief investment officer for Kleinwort Hambros, lists a few: 

  • Reducing bond positions
  • Reducing bond duration
  • Purchase of linkers (inflation-linked notes), floating rate notes and inflation swaps.

Kamal adds: "It has been a particularly difficult year for bond markets across all sub-segments, with the exception perhaps of short-dated linkers.

"At this late stage of the economic cycle, it would appear sensible to incrementally rotate out of credit into governments, to opportunistically increase duration risk, to strategically reduce credit risk (from more cyclical to less-cyclical names)

A Pimco spokesperson states: "Investors are getting paid more if you believe, like Pimco does, that central banks will ultimately get inflation back closer to their target over the next couple of years.

"It's hard to time an entry point perfectly, but we are becoming more constructive about interest rate levels more broadly.

"This volatility, although it feels terrible living through it, is creating potential opportunities across sectors that could generate an attractive yield without going down the credit spectrum too significantly."