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BLOG: Interest rate risk looms large for bonds

Written by: David Katimbo-Mugwanya
Market forecasters have consistently, and unsuccessfully, predicted the demise of a bond bull market for three decades. But in the Brexit aftermath, investors should take stock of fixed income allocations and consider whether interest rate duration risk is being appropriately compensated.

Duration is the common term applied to risk associated with the sensitivity of a bond’s price to movement in interest rates. The higher a bond’s duration, the greater its sensitivity to interest rate changes and vice versa.

So should bond investors with heavy duration risk exposure be worried? The prevailing monetary policy guidance is a useful barometer to determine whether we can anticipate a rising rate environment. Gilt yields leaped recently on hawkish Bank of England commentary noting that rate hikes may occur sooner and at a faster pace than currently anticipated.

Further Brexit clarity, upon the agreement of transition arrangements, could also support the case for higher interest rates while recent credit spread widening serves as a timely reminder that the prolonged period of depressed yields may be drawing to a close. As we navigate the final stages of this extended market cycle therefore, the risk of duration looms large for bonds.

Positioning for the next phase

Given the low levels of yield and risk premia on offer by the broad market, we do not believe duration risk is being adequately compensated by the markets. This particularly rings true in the face of what looks like an inevitable global monetary policy tightening cycle, led by the US Federal Reserve. By investing in high-quality and short-dated corporate bonds, investors are able to gain exposure to yield in excess of cash without material exposure to interest rate sensitivity, thereby preserving capital.

In a market driven to lofty heights by extraordinary levels of policy stimulus, it is, nevertheless, imperative that investors adopt a discerning strategy to seize opportunities at the short end of the yield curve. A cautious yet dynamic approach could prove crucial amid potentially volatile conditions ahead. While corporate bonds are relatively expensive in a historic spread context, we continue to find value in niche areas of investment grade debt.

Credit quality control

Within the asset class, a look back over the last decade has shown that lower credit quality underperforms in periods of credit stress, with spreads widening more considerably in this segment of the corporate bond universe. We believe by holding an average rating of single-A or higher, investors can mitigate against such a scenario.

For illustration, we can look to the bond issue of A2 Dominion 4.75% 2022. A2 Dominion is a socially-conscious residential property group providing affordable, private and social rented homes in London and southern England. The bond is A+ rated by Fitch and has an attractive yield of 2.6%.

Another example is the European Investment Bank (EIB) 2.5% 2020 which, despite a yield of 1%, directly funds projects that address climate change including the production of green energy via solar, geothermal, waste-to-energy plants and offshore wind farms. The EIB is the world’s largest multi-lateral bank, possessing the highest average credit rating of AAA.

Another tool investors can employ to insulate against a hike in rates, is the floating rate note (FRN). FRNs are mostly collateralised against a high-quality pool of assets and returns have a positive correlation with benchmark interest rates. FRN coupons automatically track interest rates.

In an environment where yields achievable by holding cash look meagre, coupled with the potential adverse impacts from duration and credit risks, we view high quality short-dated debt and FRNs as protective alternative measures against an impending tightening rate cycle.

David Katimbo-Mugwanya is manager of the EdenTree Amity Short Dated Bond fund

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