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With US interest rates expected to rise today, Iain Stealey of JPMorgan Asset Management has reminded investors of the impact further rate hikes could have on bonds.
Bonds, a form of IOU issued by governments and companies when they borrow money, have traditionally been regarded as ‘safe’ or defensive investments because they mostly pay a fixed level of interest.
However, their sensitivity to changes in interest rates and inflation can make bonds dangerous at times: the former is bad because higher interest rates makes their fixed coupons look unattractive; while higher inflation erodes the value of their fixed income.
So when interest rates and/or inflation rises, bond prices tend to fall, said Stealey, manager of the JPM Strategic Bond fund. He said a rule of thumb was that a 1% rise in interest rates could see bonds fall up to 10%.
Although UK interest rates are unlikely to rise this year and even next as the Bank of England waits to see the economic impact of Brexit, a rise in its base rate from an all-time low of 0.25% is inevitable at some point.
Stealey (pictured) suggested investors consider the impact of a 0.5% rise on their bond holdings. ‘Even if they lose half [of the 10%] that is still a lot for income investors,’ he said. ‘The chances of capital preservation are skewed to the downside.’
JPMAM’s chief market strategist Stephanie Flanders said the notion that bonds were a ‘super safe’ asset class was no longer true. ‘Investors look for a mixture of capital gains, security, preservation of capital value and income and we thought equities [shares] provided capital gains and bonds provided income and that was the model,’ she said.
‘Now we have capital gains from bonds as prices have gone up and returns have gone down and increasingly we are getting income from equities as dividends are higher than bond yields,’ Flanders added.
Bonds’ sensitivity to interest rates is shown by their ‘duration’, which measures how much their price would move in a year in response to a 1% change in the cost of borrowing. Longer-dated bonds, which have ten or more years to maturity, tend to have a higher ‘duration’ or risk from higher rates. Not surprisingly, Stealey said he had cut the ‘duration’ of his bond fund in preparation for higher rates.
Although UK interest rates are not set to rise, the manager dislikes UK government bonds, or gilts, believing they have become too expensive and offer too little income to protect investors from higher inflation.
‘For every year of duration risk you take, you used to get 1% yield,’ he said. ‘But now [on UK 10-year gilts] you are getting 1.25% over nine years of duration, so 0.15% of yield for every year…it means you are not being compensated for the risk you are taking.’
Stealey admitted he has had concerns about rising interest rates for four years and each year has been proved wrong but added ‘I think the global backdrop is a bit better now’, describing the combination of low inflation and rising growth as a ‘Goldilocks’ scenario with the global economy neither too hot or too cold.
‘Corporate earnings have been good and improved in the last year. And fixed income has done well because there has been no inflation,’ said Stealey.
The UK is unusual in seeing a jump in inflation to 2.9% up from 0.3% a year ago. This is a result of the fall in the pound since the EU referendum that has made imports into this country more expensive, putting pressure on consumers and retailers.
The US Federal Reserve is expected to raise its ‘funds’ rate by 0.25% to 1.25% this evening. This will be the third rise since December 2015 when the central bank began to tighten monetary policy, having held interest rates at a record low of 0.25% for seven years after the 2008 financial crisis.
Investors will look to see what Fed chair Janet Yellen says about how quickly interest rates could rise in future. Recent signs of weakness in the US economy and scepticism of president Trump’s ability to push through tax cuts and infrastructure spending to stimulate growth have left many thinking the pace of tightening will be gradual.
According to Stealey, that leaves the door open for a market shock if Yellen indicates the Fed may be more aggressive.
‘The markets are assuming Donald Trump gets nothing done,’ said Stealey. ‘It’s a total 180 from 18 months ago when people said he was the saviour because he was going to build new schools and bridges and roads, and now the market has gone the other way. The risk is he builds some bridges and gets something through.’
In Europe, Stealey criticised the European Central Bank for continuing to pump €60 billion into bond markets every month, an ‘emergency level’ solution that was out of step with the improving economic prospects of the eurozone.
Although bonds are throwing up more risks than investors might expect, Stealey said there were still opportunities.
While adverse to gilts, he said: ‘I like parts of Europe and the US…and some more liquid emerging markets where we see good things happening and you can get yields there’.