Rethinking Fixed Income as higher rates loom (Archived)
Despite repeated reminders that “tapering does not mean tightening,” the US Federal Reserve’s announcement of asset purchase reductions at the end of 2013 signalled to many investors the long road to monetary policy normalisation and higher interest rates has begun. Even if policy rate rises are a long way off, fixed income investors are already thinking of ways to protect their portfolios.
David Leduc, chief investment officer at Standish Mellon Asset Management, agrees rate rises will be gradual and sees little inflationary pressure on the horizon. Indeed, he says deflation risk in Europe and Japan remains a more immediate concern. As the Fed continues to scale back its quantitative easing program, this will put upward pressure on bond yields. According to Leduc, the yields on 10-year Treasury notes have already moved into a fair value range of between 270 and 370basis points.
“We’re positioned to see slightly higher yields from here. We’d expect that a level near the low 3s is reasonable,” he says. This upward movement is likely to come in the form of a gradual rise rather than a dramatic shock. Andrew Wickham, head of UK fixed income at Insight, expects short-term policy rates will remain on hold in the US, UK and Japan. “If there is a policy rate change in the G4 during 2014,” he says, “it is likely to be a cut in Europe, if the threat of deflation grows.” In the UK, Wickham sees stronger growth next year that might challenge the Bank of England’s Monetary Policy Committee to reframe its forward guidance criteria, but he views a move in interest rates as very unlikely. Like Leduc, Wickham believes the market already anticipates much of the potential interest rate increases in coming years, through steep yield curves and relatively high forward rates.
Managing Interest Rate Risk with Diversification
The prospect of rising rates means many investors are reconsidering their allocations to fixed income, particularly to long duration assets. Leduc says sectors such as long duration Treasuries, long-duration inflation-linked bonds, US mortgage securities and markets such as Germany are likely to become less attractive to investors as rates rise. But rather than looking only to avoid newly unfavored asset classes, he says investors should choose fixed income strategies that suit their investment objective. With that in mind, investors focused on total return might want to consider shifting a portion of their fixed income allocation to shorter-duration, actively managed bond strategies. They could also consider opportunistic fixed income strategies that seek to provide positive returns regardless of the interest rate environment.
Leduc also suggests diversifying into emerging market debt, local emerging market interest rates in certain countries and dollar-denominated emerging market bonds, particularly higher quality corporate and quasi-sovereign bonds. He points to attractive relative value opportunities in global investment grade bonds, high-yield bonds and certain parts of the bank loan market.
Wickham emphasises the need for fixed income investors to understand their own investment objectives, first, regardless of whether interest rates are rising. “Pension fund clients need to put in place a comprehensive asset allocation and governance structure to move from wherever their plans are today, to a fully funded and risk managed destination that reflects both their liability profile and the returns they need to generate from their assets,” he says. “This will necessarily be unique for every plan. Insight believes in outcome-oriented solutions rather than generic one-size-fits-all prescriptions.”
Wickham believes investors are paying too great a premium for the perceived liquidity of sovereign bonds and traditional credit and he suggests they look to other types of assets. “The risk-return profile of some asset-backed securities and products that have usually been the domain of the banks, such as commercial real estate loans, remain very attractive in spite of the record low yields of other fixed income investments,” he says.