Boosting your fixed income holdings to counter-act share market volatility is a risky play in a rising rate environment, writes Nicki Bourlioufas.

As share market volatility ticks up, many investors are increasing their portfolio allocations to bonds. But debt securities may fall in price too if interest rates keep on rising.

Traditionally, bond prices and equity prices move in opposite directions, that is, when share markets rally, bond prices fall. The opposite also may hold; bond prices may rally when share markets sell off as investors seek the safety of the government bonds. The best example of this was during the Global Financial Crisis, when bond funds returned positive gains while share markets tanked.

However, in an environment when interest rates are rising, bond prices may fall along with equities. October is a good example. While share markets corrected, the yield on the 10-year government bond, which move in the opposite direction to price, rose to 2.68 per cent, up from 2.63 per cent in September.

Five-year bond government yields also edged higher by 3 basis points to 2.68 per cent. The S&P/ASX 200 ending the month at 5,830, down from 6,208 in September. So both asset classes fell in value.

Federal Reserve

US five-year bond yields edged higher during October

Some experts are predicting further rises in bond yields as interest rates rise around the globe in coming months, led by the US.

Justin Tyler, interest rates and currency portfolio manager, Daintree Capital, says a further synchronised upswing in global growth could push US treasury yields into the 3.5 per cent to 4 per cent range, up from around 3 per cent at the time of writing.

“We don’t think those yield levels will be seen on a consistent basis for some time yet, although over the longer-term we retain a strong view that a gradual move higher in US treasury yields is the most likely outcome,” says Tyler, who also expects Australian government bond yields to rise in coming months.

Janus Henderson Investors also predicts higher bond prices as US interest rates rise. “We still see some upside pressure on longer-dated yields from a modest cyclical lift in global inflation and increases in sovereign debt supply as fiscal policy is eased at a time when central banks are moving from quantitative easing, to quantitative tightening,” says Frank Uhlenbruch, investment strategist in the Australian fixed interest team.

“We are still looking the Reserve Bank of Australia to commence a modest and drawn-out tightening cycle commencing late 2019,” he says.

According to Daintree’s Tyler, given the risk of higher bond yields, a careful selection of fixed-income assets is essential to ensure bonds’ defensive element in a portfolio.

“While bonds are the defensive asset of choice for most multi-asset portfolios ...the trick is to ensure that the defensive qualities of your bond allocation are reliable in different market environments, and that the income earned from the allocation is optimal in the context of retaining defensiveness across the portfolio," he says.

Tyler believes the practice followed by many fund managers, of "dialling up" their credit risk to boost bond portfolio yields, "is harmful in a market downturn, when such bond portfolios tend to underperform".

“Equally, we believe many investors are taking a very significant view on interest rates in their portfolio through overweight holdings to government debt. That may be a way of increasing the defensive characteristics of the portfolio when required, but it comes at the expense of significantly degraded returns through time,” says Tyler.

In a rising interest rate environment, both the total returns and also the defensive performance of government bonds is significantly reduced – and this is before considering the very low yields on offer in many government bond funds at present.

“An absolute return style of bond fund is likely to offer more compelling risk-adjusted returns in the current environment,” says Tyler.

If share markets continue to correct, bonds may ultimately benefit, according to AMP Capital’s Ilan Dekell, head of macro.

“As the market shifts its expectations from easy policy to tighter policy, equities must be repriced, and indeed that is what we are seeing at present. Higher volatility will continue as riskier assets become less attractive versus bond yields and while the market considers when the end of the cycle may occur.

“As policy tightens and equities sell off, confidence comes under pressure as people feel less wealthy, and borrowing costs rise, ultimately supporting bonds, as this feeds negatively into growth and inflation expectations,” says Dekell.

For investors, with volatile times ahead, it will be important to ensure their portfolios are well diversified with both equities and bonds. But there is no guarantee that bonds will provide the strong protection against portfolio losses as they did during the GFC.


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Nicki Bourlioufas is a contributor for Morningstar Australia.

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