Fixed-income yields have been falling for the past few decades, and despite the recent uptick since summer 2016, are currently at the lower end of their historical range.
It is not only government bond yields that are low, but also yields for much of the fixed- income universe, including global investment grade, high-yield bonds, emerging market (EM) debt and other fixed income assets.
Given the view that the US Federal Reserve will continue raising interest rates, and bond prices in the market will echo those rises, the 30-year-plus downtrend in yields looks to be going into reverse, albeit slowly and with some resistance. This paradigm shift means that investors will need to pay close attention to the fixed-income holdings in their portfolios.
Returns from fixed-income investments might be hit substantially by rising rates. The chart shows the hypothetical impact of a 1 per cent rise in local interest rates on selected fixed income sub-asset classes.
Government bonds would likely be affected the most while the juicier coupon payments of high yield, EM debt and convertible bonds would offer a buffer to the losses, even making the return effects positive in some scenarios.
Don’t put all your eggs in one basket
As well as looking at their duration risk, investors may therefore benefit from broadening their fixed income horizons. Global bond markets offer investors a wide array of options, each with its own risk and return profile.
And it is important to note that no single sub-asset class has outperformed the others consistently during the past few years.
A diversified approach – one that focuses more on higher-yielding securities, not only government bonds – could provide robust total returns, even in a rising rate environment.
As well as rising coupons, some areas of the market might be supported by technical or other factors.
Although the fundamentals of investment grade bonds, such as leverage and interest rate coverage, are not at their best levels, robust demand from institutional investors has lifted the prices during the past six years and might continue to provide support.
Upsides for other markets
Meanwhile, in emerging market debt, since many EM currencies have already weakened substantially against the US dollar, the upside for asset prices in these currencies and countries might be higher than before, and the risks somewhat diminished.
Leverage measures are reassuring for both US and European high yield. The energy sector within the US high-yield universe, for example, is no longer held back by the burden of a low oil price.
However, the European high yield market is higher quality and has a substantially different sector composition than its US equivalent, meaning it can provide portfolio diversification.
Investors should expect rising yields in core bond markets, and be aware of the potential implications for capital returns in portfolios. But this does not mean all fixed income should be avoided; in fact, some fixed-income assets will benefit from a rise in yields.
