LET’S FACE THE MUSIC AND DANCE
We are all being inundated with commentaries at the moment about the
implications of rising interest rates for bond investors. With some sense of
irony at the idea of trying to cut through the noise by adding to it we will
we have a more sanguine view than most on the future for bonds. It was
famous retort to trouble ahead “Let’s face the music and dance”.
Over the course of this note we will provide you with our answers to
the questions we see as key to navigating this challenging environment.
We will start by looking at how central bankers expect interest rates to
rise in the coming years and then we will look at what this means in
terms of returns for bonds. Before I begin I must point out that these are
not intended as predictions. They are simply rough guides to help us
understand the balance of risk and reward.
For bond investors the yield is one measure. While it gives buy and
hold investors an indication of return there are complicating factors for
investors who may have to sell before maturity. For them rising yields
mean lower prices however they also mean higher income returns.
interest rates rise. One of the most considered views available on this
below.
This is based on a vote by arguably the people with the most information
about the future of monetary policy. They see rates starting to rise next
year and reaching a level of around 3.75% by 2017. I will use US interest
rates to illustrate my argument for the sake of clarity as the conclusions
are the same for Sterling interest rates.
From here we can answer the question, what will bond returns look like
if interest rates rise as expected over the next 3 years? For the sake of
conciseness I will skip over a few assumptions here.
each other. So you would receive your income however you would lose
an equal amount in capital erosion leaving your total return hovering
around zero. Not a hugely attractive proposition.
Corporate bonds fare better assuming credit spreads remain stable.
Something they have done in the initial stages of previous growth driven
tightening cycles. You collect your premium less any defaults meaning
a good corporate bond or high yield manager should be able to provide
modest positive total returns roughly in line with credit spreads on a per
annum basis. These are currently around 1% on investment grade and 4%
on high yield. Clearly this is better than government bonds however the
capital gains of the last few years look like they are behind us.
So government bonds look quite challenged in this consensus
environment and corporate bonds look modestly better. That is only half
the story however. Our next question must be about what if that does not
happen?
For a 10 year government bond a rise in yield to 4.75% rather than 3.75%
puts you down around 9% including income at the end of our theoretical
3 year period. We can see that a modest overshoot in interest rates
produces a pretty disappointing return.
For corporate bonds you also have the risk of widening credit spreads.
Source: Federal Reserve
strengthen and widen as they weaken. A nice feature of this relationship
is that they tend to move in the opposite direction to interest rates over
the medium term and as such provide corporate bonds with a natural
hedge against rising rates. Thanks to this dynamic we see the downside
in corporate bonds as closer to a zero total return if rates rise to 4.75% and
spreads remain at current levels. This is clearly preferable to the outright
losses on government bonds.
With the caveat that shorter time frames will invariably be more volatile
than longer ones we can draw some conclusions:
•
poor with little expected return to justify the risks of owning them.
• We therefore have a preference for credit which looks better set to
In our income strategies we are proceeding with caution. We are
deploying capital where we see areas of value and are being careful not
to overstretch. We want to maintain a diverse set of asset classes and
maintain liquidity. Through this approach we can achieve our return goals
if the consensus scenario proves to be correct while also controlling risk if
it does not.
One area we would recommend bond investors consider if they have not
already is equity income. While equities may experience higher volatility
than bonds in the short term, they have historically fared better over
longer periods as interest rates start to rise. The full debate on equity
income is however another note in itself.
I hope this note has proved interesting and if you have any questions
please do not hesitate to contact the team at Ravenscroft Investment
Management.
Source: Economist.com
Robert Tannahill
Ravenscroft Investment Management