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Further scare ahead for fixed-income investors

Glenn Freeman  |  31 Mar 2017Text size  Decrease  Increase  |  
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Interest rate risk is ratcheting up, with a high likelihood of international bond returns slipping into negative year-on-year figures by June 2017, says the head of credit specialist Bentham Asset Management.


Six-month returns for global corporate and governments bonds are already in the red--at negative 2.3 per cent, 2.5 per cent, and 3.5 per cent for Australian fixed-interest, global government bonds, and US corporate bonds, respectively.

While 12-month returns are still in low positive figures, this is set to change, says Richard Quin, Bentham's managing director and lead portfolio manager.

"It's quite likely that we're going to see negative year-on-year numbers for fixed interest, as we're starting to see interest rates rise," Quin says.

"So, by June, the one-year numbers will be negative for global bonds, and that's a big issue, especially when a lot of conservative portfolios have predominantly global bonds in them."

He believes these negative returns are likely to persist for "the financial year at a minimum, but I don't think it's going to be just one year; I think it could be two or three."

Quin predicts a knee-jerk, sentiment-driven reaction from many fixed-income investors: "They're going to bail out, they're going to vote with their feet."

Expanding duration risk is a key reason so many fixed-interest investors are exposed.


Past returns and yield to maturity, with historical volatility


Source: Bentham Asset Management


"You've been seeing governments and corporates borrowing longer and longer term, extending their interest rate duration. We've gone the opposite direction, we've been short interest rate risk. That's part of the reason, along with credit spreads, why we've delivered positive returns in the last 12 months," Quin says.

Bentham Wholesale Global Income [10751] holds a Morningstar Silver rating. An actively managed fund with a dynamic approach to duration, it has broad exposure to various parts of the credit market.

"The fund won't have the same defensive characteristics as the typical fixed-interest manager but will pay off handsomely if rates rise," says Morningstar manager research analyst Elliot Lucas.

The role of credit assets

Bentham's Quin emphasises the important role fixed-interest assets play in diversified investment portfolios.

"The big thing that credit does well is provide some protection to investors, but it provides very good income above that of bonds and usually shares, and in a reasonably consistent manner. But it also allows you to protect your capital ... you get preferential treatment as a debt investor relative to an equity investor who sits at the bottom of the capital structure if something goes wrong at the company," he says.

Referring to the latest official interest rate increase by the US Federal Reserve, which some commentators described as "dovish" in only increasing by 25 basis points, he instead views this as a calculated management of market expectations.

Quin suggests a sharper rate increase may have prompted a bond market sell-off, "which would make it harder for them to introduce another increase ... the whole idea is to keep people calm while you're raising interest rates".

"People did not expect a rate hike in February, or in December last year--the market was not pricing that in, and that's why markets sold off. In any case, the market was massaged into foreseeing that it would become an event."

With a consensus view the US is aiming to get the interest rate to 3 per cent, a further two 25-basis-point rate rises are expected in 2017.

While some commentators anticipate another 75-basis-point increase in 2018 and the same in 2019, Quinn believes it is unlikely to be so equally measured.

"My expectation is that you will never get three 75-basis-point increases ... I think they're going to be a little bit more aggressive. And they will check how the economies around the world are reacting to the rate hikes--and to be honest, they're not reacting at the moment, so it looks as though they may do more increases."

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Glenn Freeman is Morningstar's senior editor.

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