INTEREST RATES AT AN INFLECTION POINT
November 2017 heralded a significant milestone in the recent history of the UK’s monetary policy, as the Bank of England voted 7-2 in favour of lifting interest rates from 0.25% to 0.5%. However slight this might seem, it is the first rate rise since July 2007 – an extended period of time in which we have seen extraordinary levels of monetary stimulus. This first interest rate hike is very likely indicative of a gradual normalisation to monetary policy, which the Bank of England has planned by guiding towards a base rate of 1% by the end of 2019.
This phased and well sign-posted implementation approach to policy tightening is somewhat more palatable for bond investors. Bond prices and yields have an inverse relationship, so a rise in interest rates inevitably leads to a fall in prices and vice-versa. Many expected the bond market to weaken following the central bank’s announcement, however the fact that the accompanying forward guidance pared back expectations of further interest rate rises in the immediate future meant that bonds actually rallied swiftly after the policy action.
INCREASING RISK LEVELS
A muted reaction to the rate rise was the best possible outcome in light of the fact that, in recent years, investors have piled into the fixed income markets in their quest to maintain income levels in the aftermath of heavy central bank intervention. This ‘search-for-yield’ has seen bond prices rise – and therefore yields fall – in turn leading to investors taking ever greater risks in order to eke out income from their fixed interest allocations. This has mostly occurred through investors purchasing longer duration bonds, although exposure to High Yield and Emerging Market debt have also been popular strategies.
Had the announcement contained a hawkish surprise, bond investors could have witnessed a sharp sell-off in the fixed income market from levels not far off their historic highs. How the market reacted at this point therefore, was actually more of a function of what the Central Bank is signalling about its outlook for monetary policy, rather than the actual restrictive policy action.
SHORT DURATION STANCE
This outlook raises the question of whether fixed interest is still an asset class worth considering given the adverse impact of tightening policy actions on bonds.
The short answer is yes, as not all bonds are created equal. Even though rising interest rates might lead the asset class to struggle overall, it is entirely possible for some bonds to react differently to rising interest rates. For example, fixed coupon bonds with the longest time to maturity have a higher sensitivity to interest rate movements than those redeeming over a shorter time-frame. Assuming a uniform interest rate rise across all tenors of the yield curve with all else equal, longer-dated maturities would see larger price declines. Traditionally, yields on shorter-dated bonds have also demonstrated a higher correlation to central bank interest rate rises compared to their longer-dated counterparts whose yields are arguably more attuned to inflation expectations. For floating rate notes, higher interest rates actually have a positive impact on returns as coupons increase in parallel.
So the more pertinent question is not whether fixed income is an asset class worth investing in, but rather, how one should best adapt their investment strategy to the prevailing outlook.
The impact of further interest rate rises can be mitigated by lowering fixed coupon bond portfolio durations and or increasing allocation to floating rate securities, which are poised to benefit from higher interest rates. Another decision that fixed income investors may wish to make soon, is to dial back on the amount of risk they are exposed to. We believe that the extreme levels of stimulus have fostered a false sense of calm which masks the true magnitude of potential risks, especially at the long end of the yield curve. One such risk is that sustained increases in price inflation in excess of the Bank of England’s 2% targeted level will come through.
Higher inflation diminishes the spending power or real return on cash. For investors biased towards capital preservation in the present environment, relative returns can be enhanced by shifting your fixed income allocation towards shorter duration bonds. These will provide a yield pick-up compared to government bonds, whilst keeping risks such as duration within acceptable parameters.
THE CONTINUED IMPORTANCE OF FIXED INCOME
Fixed income will continue to play a defining role in an investor’s toolkit as bonds typically pose less of a risk to capital than equities, thereby facilitating capital preservation in a diversified portfolio. A dynamic investment approach that anticipates the impact of future developments including monetary policy, credit risk and inflation, whilst re-positioning portfolios accordingly, is key however. A slow-paced turnaround in monetary policy is set to continue. Potential risks on the horizon as policy normalisation takes hold, could manifest in the form of a price correction at the riskier end of the credit spectrum or for longer-duration bonds, where rising inflation would hamper asset class returns. Given cash is unable to provide sufficient income nor defence, we believe that a higher allocation to high-quality short-dated bonds offers a better alternative for the times ahead.