Rising rates and bond markets: keep calm and clip on
The global economic recovery from COVID-19 is expected to be one of the strongest in living memory.
Rising rates and bond markets: keep calm and clip on
- Accordingly, it’s not surprising that investors are thinking about the risk of meaningfully higher interest rates and falling bond prices.
- It is important for investors to remember the important role fixed income investments have in diversifying portfolio risk regardless of market conditions.
Global bond yields have risen over the past year, with the average yield on the Bloomberg Global Aggregate Bond Index climbing by roughly 40 basis points over the 12 months ending December 31. Recent changes in Canadian bond yields have been even more dramatic as the average yield for the FTSE Canada Universe Index increased 80 basis points over the same period. The rise in yields has been driven by several factors, including the rollout of COVID-19 vaccines and a gradual reopening of the economy. The impact has led to significant increases in economic growth for most developed nations. As more countries reopen their economies, extraordinary monetary and fiscal stimulus has not only allowed economies to weather the impact of the pandemic but has fueled a rebound in employment leading to an imbalance between demand-driven growth and supply. Not only has this pushed prices higher in key economic sectors such as food, housing, and energy, but surging demand has led to bottlenecks in the supply chain and further exacerbated the situation. Headline inflation rates have clearly moved higher, and expectations for abnormally high inflation remain heightened, adding further upward pressure on yields.
With bond prices moving inversely to yields, some fixed-income investors are understandably concerned about the possibility of falling bond prices. Experiencing a price decline in any asset can be disconcerting. This is why SEI focuses on helping clients build well-diversified investment solutions to help protect against downside risks and market volatility. Maintaining exposure to core and investment-grade bonds plays a critical role in managing these risks even in the unlikely case of a longstanding move to significantly higher bond yields.
Why Own Bonds?
With interest rates still at historically low levels, some investors are asking whether there is still a role for core, investment-grade bonds in a diversified portfolio. We believe there is. First, bonds can provide meaningful income generation. While the current income received from bonds is quite low compared to history, we believe the relationship to cash and yields on riskier assets are within reason as compared to those of the last 25 years.
With no other consideration than the comparison of current yield levels to historical averages, an investor might conclude that core bonds are overvalued. However, just because core bond yields are at historic lows, they aren’t necessarily overvalued owing to where the yields on other asset classes sit (the opportunity cost). An investor who desires greater income might have to take on additional risk/duration/illiquidity. As with any portfolio repositioning, the change in exposure comes with tradeoffs that should be balanced with other goals and objectives. In other words, we think that the current level of core bond yields can be justified given everything else in the current state of financial markets. Additionally, bonds still provide valuable diversification benefits. Because the returns on high-quality bonds tend to behave differently than the returns on riskier, growth-oriented assets like stocks, they can help lower the volatility of an overall portfolio. In other words, in an optimal investment portfolio, some assets should rise when other assets fall—which is often what happens in the relationship between stock and investment-grade bonds1.
A Multi-Decade Tailwind
A nearly four-decade-long downtrend in global interest rates, as shown in Exhibit 1 (download the full commentary to see exhibits), provided a longstanding boost to bond returns. The broad downtrend in global rates continued into mid-2020, falling to record lows in many countries as the global pandemic took hold. Interest rates have since moved higher, thanks to strengthening growth and inflation outlooks fostered by forceful policy measures and the arrival of effective vaccines. Thus, the more interesting (and perhaps pressing) question is how serious the risk of higher interest rates is to future returns on investors’ bond holdings.
Keep reading. Download the full commentary below.
<p><em><sup>1</sup>For a deeper look at the strategic asset allocation case, see our January 2021 commentary, “Are Investment-Grade Bonds Still Worth Holding?”</em></p>
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