Bonds Investment Strategy 2015

09.09.2014

Author: Maria Boychinova, Head of Research at Expat Aset Management

The article was published in Investor.bg

Bonds performed very well for the last couple of years, driven by the policies implemented by central banks to support the markets, the historically low interest rate levels, and the recovery from the 2008 crisis. Risk appetite grew amongst investors, which drove credit spreads to historically low levels.

At the same time, interest rates on US and European riskless and low-risk instruments fell substantially. In the medium and long term, we expect market interest rates in Europe and the US, as well as credit spreads to rise. This will have a negative impact on fixed income markets. In such a scenario, investors must consider a strategy to restructure their bond portfolios.

What determines bond prices?

1. Risk from rising interest rate levels
Interest rates and bond prices are negatively correlated – when interest rates rise, bond prices fall. An increase in interest rates affects foremost instruments with a fixed coupon and many years to maturity. Let us say that bond X trades at par value, has a fixed annual coupon of 5%, and matures in 30 years. The interest rate in the economy for a risk level lower than that of bond X is 2%. Investors agree to an annual yield of 5% on bond X for its level of risk, resulting in a price equal to the face value of the bond. The central bank however decides to raise interest rates from 2 to 4% by financing central banks at lower interest rates and/or by selling government bonds (aiming to reduce the supply of money, thereby increasing interest rates). Investors could receive an interest of 4% if they deposited their money in a bank or bought government bonds on the market and they are no longer willing to pay the par value for a bond with a higher risk and a coupon of just 5%. Hence, they start selling the bond until its price falls to a level that makes the bond's yield attractive again (for example, a yield of 7 or 8%).

2. Credit risk or a risk of default
Corporate bonds are debt issued by a company. Whether this debt will be repaid depends on the financial condition and development of the respective company. The yield of corporate bonds has to be high enough to compensate investors for the credit risk they take. To a large extent, a bond's credit rating reflects its credit risk. Bonds with a rating of BBB- (by S&P and Fitch) or Baa3 (by Moody's) or higher are considered investment-grade, while bonds with a rating of BB+/Ba1 or lower have a speculative profile (also called "junk").

3. Systematic risk
Also known as ‘volatility' or ‘market risk'. This type of risk cannot be completely avoided but its impact can be minimized by hedging or by a well-developed allocation strategy among different asset classes, in different geographical zones, currencies, and economic sectors.
These three main types or risks associated with bond investments are now close to their lowest historical levels, and it seems that the potential for further decreases has been exhausted. On the contrary – concerns are that in the next years these risks will rise, which would lead to a decline in bond prices.

When will central banks increase interest rates?

One of the most discussed economic topics in 2014 is the future interest rate policy of central banks. It is expected that interest rates will be raised first in the U.S., where economic fundamentals have greatly improved, and the Federal Reserve has not increased rates since May 2006.

Every quarter, the Federal Reserve publishes its expectations for the benchmark interest rates. The June 2014 report showed that most members of the Federal Open Market Committee expect the benchmark federal funds rate to reach 1.00-1.25% by the end of 2015. At the moment, the target level is between 0.0% and 0.25%. Increasing the interest rate level in the U.S. will most likely have a negative impact on fixed income instruments because of the reasons described in the example above. For some time, the real rate of return (the nominal rate adjusted for inflation) of the 5-year U.S. treasuries has been negative – another indication that nominal interest rates will be raised until real interest rates become positive again.

A change in interest rates affects long-term bonds the most. Every bond has a characteristic called duration which measures its sensitivity towards changes in interest rates. The longer a bond's time to maturity is, the higher its duration is. The higher the duration, the larger the change in the bond's price is for a given change in interest rates. For example, consider a bond with a modified duration of 5 (maturity in approximately 6 years). All else equal, if the interest rate level rises by 1%, its price will fall by 5%.

Is there a bubble in the speculative bond market?

Over the past few years we notice a stronger investors' interest towards riskier assets, including speculative bonds. There are many reasons for that, among which are: a search for higher yields in a period of extremely low interest rates in the economy; a global recovery from the financial crisis; improvement of the economic indicators; improvement of the companies' financial performance. This investors' interest resulted in credit spreads reaching historically low levels.

The credit spread represents the difference between the yield of two bonds with different levels of credit risk but identical other characteristics (maturity, currency, etc.) At present, the credit spread of the high-risk bonds in the U.S. is close to its historic low for the last 18 years. This can be interpreted as an indication for a speculative bubble in the high-risk bond market. If the credit spread rises to its average historical levels, this would result in a substantial and most likely sharp fall in the prices of bonds with ratings below investment grade.

How can investors protect themselves from changes in the bond market?

History shows that after certain periods of time market crashes happen. The economic and financial problems in Europe have not been resolved yet with Portugal's banking failure being the most recent example. Tensions in Ukraine and the Middle East are mounting. Volatility and uncertainty will increase in the next 12 months, but we do not expect a new financial or economic crisis in the United States or in Europe. Nevertheless, we think that we will gradually start to observe a rise in interest rate levels and an increase in credit spread towards their levels from the beginning of 2012. In periods of market uncertainty, we usually notice a ‘flight to quality'.

In such a scenario of market development, we recommend that bond investors follow some main principles:

1. Lower portfolio duration
Bonds with a shorter maturity are usually better protected from rising interest rates because even if they experience a temporary fall in price, they can still be held to maturity. Meanwhile, investors get their coupon payments, while the bond's price gradually moves towards par value on the maturity date.

2. Investments in bonds with floating coupon rates
These are bonds whose coupons are not fixed but depend on the market's interest rate. For bonds issued in U.S. dollars, coupons of such bonds are usually formed on the basis of the yield of U.S. treasuries with an identical maturity; the interest rate at which a depository institution lends funds to another depository institution overnight (federal funds rate); or the U.S. Dollar Libor plus a fixed margin.

3. Investments in money market funds
These are mutual funds investing in short-term debt securities (for example U.S. treasuries). These instruments reduce investors' exposure to credit and market risks. According to Vanguard, the average annual return of such funds in the United States for the last 10 years has been 1.35%.

4. Switch towards issuers with a high credit rating
The yields of non-investment grade bonds at the moment do not offer investors a premium high enough to compensate them for the credit risk taken. Credit spreads have reached historically low levels in a period of political and economic uncertainty in many regions of the world. In such an environment, it is better to look for investments in issuers with a high credit rating and an improving financial performance.

5. Portfolio diversification
The good diversification improves the overall performance of a portfolio. This means a balanced exposure towards different instruments, industries, and currencies.
When expecting a rise in interest rate levels, a moderate exposure towards the stock market can be a good strategy. Historical performance of the S&P 500 index shows that the stock market performs well after an interest rate increase - on average, the index has returned 31% for the three-year period after the beginning of an interest rate increase.
A rise in interest rates in an economy usually comes with strengthening of the domestic currency. Thus, during a possible increase of interest rates in the U.S. in 2015, investors who have previously turned Euro-denominated investments into U.S. dollar-denominated will probably realize foreign exchange gains.
For additional portfolio diversification, investors can add to their portfolios an exposure towards gold and oil – two sectors which in the past have had a good performance in times of market uncertainty.

6. Hedging
There are financial instruments which are negatively correlated with the bond market - when bond prices fall, these instruments rise. An example of such an instrument is ProShares Short High Yield ETF, which takes short positions against the U.S. speculative bond market. The performance of this fund is inversely related to the performance of the Markit iBoxx $ Liquid High Yield Index - an index of liquid bonds with a non-investment grade credit rating, denominated in U.S. dollars. Currently, the price of ProShares Short High Yield ETF is at its lowest since the inception of the fund in 2011 because of the strong performance of the high-risk dollar-denominated corporate bonds sector.

7. A selection of undervalued bonds
There are bonds on the fixed income market that offer a higher credit risk premium than the average premium for similar instruments. The attractive yield is normally linked to worsened performance and an expected downgrade of the company's credit rating. For some bonds, however, there is no objective reason for the more attractive credit spread. We believe that these bonds are undervalued and we expect a rise in their price.

* The article has analytical nature and is not a recommendation for purchase or sale of securities.