Overview
As we head towards the end of the year, the investment landscape remains enormously challenging across almost all asset classes. The S&P 500 stock index has fallen into “correction” territory as investors worry about interest rates, increasing geopolitical risks, and lacklustre corporate earnings. Equity markets across the globe have struggled for much of the year and bonds have also had another very difficult time following on from the annus horribilis of 2022.
Throughout October, the horrendous news from Israel and Gaza, which is first and foremost a massive humanitarian crisis, has elevated the already highly charged geopolitical tensions to levels that very few of us have ever encountered. What the outcome of these tensions will be is impossible to predict but undoubtedly heighten the economic risks, particularly for oil and gas and thereby inflation.
The investment world is very different to where we have been and it has changed for the foreseeable future as quantitative easing has ceased, inflation has roared, and interest rates have risen dramatically over a short period. As the chart continues to show, staying invested in markets rather than trying to time entry and exit points is likely to pay off in the long-term. At times like these, confidence to remain invested is very challenged. This is particularly true as the foundation of portfolios, bonds and other fixed income instruments have been badly shaken.
Some of the recent bond market volatility has been driven by the horrific events unfolding in the Middle East. It is too early to assess the impact of this conflict for world markets, although the immediate reaction was perhaps more muted than might have been expected.
Investors are trying to work out whether the prospect of higher oil prices damages economic growth, and therefore reduces the outlook for interest rates, or whether higher inflation puts the central banks in an even tighter spot and feeds the “higher for longer” narrative. This elevation of uncertainty and the impact on inflation and interest rates does nothing to calm bond markets in the short term.
Bonds and interest rates
Recent volatility in bond markets in relation to interest rate expectations has presented another test of confidence for investors, particularly those in lower-risk, high bond allocation portfolios. However, the higher-for-longer interest rate outlook is a major reason that investors should hold their nerve amid the uncomfortable turbulence.
As interest rates increased, the yields on 10-year government debt in the US, Euro area and UK rose resulting in bond prices (the capital value of the bond) falling following central bank policy meetings and key inflation data releases in late September. Comments from the US Federal Reserve and the Bank of England suggested interest rates may not come down as early as markets had been expecting. The market consensus at the time was that interest rates would start falling in early 2024, so this was an unexpected and unwelcome surprise.
Interest rate expectations are a key factor in bond prices, so understanding how bond markets tend to move in response to interest rates can help investors make sense of market turbulence and crucially ultimately focus on the long term.
An increase in interest rates pushes the price of existing bonds down, while falling rates would typically see long-term bond prices rise. This repricing of bonds is based on the return an investor would receive if they held the bond to maturity (yield-to-maturity). If rates are going up, existing bond prices tend to fall because investors can earn more on newer bonds with higher coupons (the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity), so the price of existing bonds typically drops, giving investors an incentive to buy those bonds. The opposite is true when rates are falling.
In the case of government bonds, expectations about future interest rates often have an even bigger impact on bond prices than actual movements in rates. This is because when the policy rate, set by central banks, is expected to rise, or fall in the future, parts of the market will adjust their bond holdings to optimise returns, which can see prices move further based on increased demand.
For example, if investors expect interest rates to fall from current levels, there tends to be increased demand for longer-term bonds as these will deliver a higher return over time than shorter-term bonds. On the other hand, if markets expect interest rates to rise, then short-term bonds become more attractive as they are less sensitive to interest rate changes.
Duration risk
Sensitivity to interest rate changes is referred to as duration risk, which is measured in years and considers a bond’s characteristics, such as yield, coupon rate and maturity.” Investors should embrace duration risk, as attempting to tilt their bond portfolios towards shorter-duration bonds can potentially limit their long-term return prospects” from a recent Vanguard paper. “The UK bond markets have been particularly volatile, owing to the changing interest rate outlook, but long-term investors stand to gain from an improved return outlook.”
It might sound like a simple relationship that investors can exploit to their advantage, but as we have seen it is not difficult for bond managers to get it wrong. If interest rates don’t move as expected, then investors that have taken a tactical position with their bond holdings could suffer far greater losses than a bond portfolio that is spread across the yield curve. A yield curve is a line that plots yields, or interest rates, of bonds that have equal credit quality but differing maturity dates. (The slope of the yield curve can predict future interest rate changes and economic activity).
Even if interest rates do move as expected, the yield curve doesn’t always move in unison. Parts of the curve may move more than other parts of the curve, and so taking concentrated positions at any point along the yield curve incurs a high level of risk.
Ultimately, bond holdings have historically offered a counterbalance to the volatility in equity markets so it’s important that investors think very carefully before introducing further risk to their bond exposures through lack of diversity and be tripped up by concentration.
While the higher-for-longer message from US and UK policymakers in September shattered the market consensus that rate cuts would come in early 2024, investors shouldn’t lose sight of the bigger picture. The aggressive rate-hiking programme by all major central banks in the past 18 months has significantly improved the long-term return outlook for bond investors, thanks to greater income returns going forward.
Conclusion
The key message for investors, particularly those with a lower attitude to risk, is that we are most likely at or close to peak rates across key markets and the long-term outlook has improved for bond investors. While rates may not come down as soon as markets had originally anticipated, if and when they do trend down, the expectation is to see long-term bond prices rise. It is worth remembering that following the peaks in each Federal Reserve hiking cycle, bonds have outperformed cash on a two-year horizon in every instance over the last 35 years and as the Bloomberg chart above shows, staying the course has a record of success.
Douglas Kearney C.A. Investment Director
The above article is intended to be a topical commentary and should not be construed as financial advice. Past performance is not an indicator of future returns. Any news and/or views expressed within this document are intended as general information only and should not be viewed as a form of personal recommendation.
