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BLOG: Beware increased bond market volatility

Mortgage Solutions
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Mortgage Solutions

The US Federal Reserve’s (the Fed) decision to end its quantitative easing (QE) programme is a significant step along the path to monetary policy normalisation – one that we believe will result in heightened market volatility.

Launched in 2010, QE has ensured the availability of a vast source of liquidity, thereby artificially engineering low market volatility over the past four years. However, the move towards policy normalisation, not only in the US, but also the UK, is likely to increase investors’ nervousness about a potentially abrupt reversal of trajectory. The recent strength of US economic data has increased the likelihood of the Fed raising rates in 2015, while, in the UK, we expect the first Bank of England (BoE) rate hike to come in the summer of 2015.

Of course, the withdrawal of central bank liquidity is far from universal. The Bank of Japan (BoJ) and the European Central Bank (ECB) both remain in expansion mode.

In October, the BoJ announced an extension to its QE stimulus package, to around ¥80bn, while the ECB recently stated that it was prepared to pump up to €1tn of liquidity into the flagging Eurozone economy. Already, it is considering expanding the scope of its current asset purchase programme to include corporate bonds. The scale, however, remains well below that of the US QE programme. As such, we believe that global liquidity is now tighter, potentially encouraging a rise in market volatility.

Nevertheless, we remain positive about corporate bonds on the basis that fundamentals continue to support very low default rates, as companies can easily refinance in the current, low rate environment. Furthermore, we are not at extreme levels in terms of valuations, meaning corporate bonds offer further performance potential in our view. However, as we expect higher yields in both the US and UK, and renewed volatility, we would argue that short-dated corporate bonds currently appear to be the best place to invest within the fixed income arena.

A key risk of investing in bonds is the capital value-eroding impact of rising interest rates: as rates increase, existing bond yields must adjust to the higher levels, and for this to happen, bond prices have to fall. Short duration bonds are a key means of reducing exposure to interest rate risk and, in turn, reducing potential capital losses.

Duration essentially measures how sensitive a bond’s price is to interest rate movements. For example, when interest rates rise, the price of a bond moves in direct relation to its duration – the higher the duration, the larger the fall in the bond’s value and vice versa. In a rising rate environment, investing in short duration bonds is therefore a key means of limiting potential capital losses.

Within our short duration portfolio, we consider bonds with an expected life-to-maturity or call date of up to five years maximum, to be optimal. They are easily held to maturity and, within a portfolio, the frequent maturities provide an attractive source of natural liquidity. This is important for a number of reasons: (i) it allows for the implementation of an active strategy with reduced transaction costs (ii) the proceeds of maturing bonds can be reinvested at prevailing interest rates and (iii) redemptions can be more easily met, with fewer implications for the rest for the portfolio.

Nicolas Trindade manages the AXA Sterling Credit Short Duration Bond fund