Are rates going to rise, and if so, when?
Will bond market volatility lower my returns?
Is the bond market getting more illiquid?
All these questions can cause anxiety, as there is uncertainty. After last week’s Fed minutes were released, the media is abuzz with predictions that the Fed will begin taking its massive foot off short-term interest rates perhaps after the FOMC meeting in June. No one knows what will happen next. Will rates rise dramatically or will the bond community respond with a yawn? What investment strategies might give investors the best chance to weather this uncertainty?
Investors already saw increased bond market volatility in 2014 created by diverging growth trajectories between the U.S. on one side and the Eurozone and Japan on the other. The divergence in the global growth uncertainty has left the U.S and the U.K among the few countries that are contemplating rate increases while most central banks are lowering theirs. What investment strategies might give investors the best chance to weather this volatility?
Liquidity in the bond market has been getting lower since 2008 due to new banking regulations that require bank balance sheets to be tighter and cleaner. Liquidity is defined as the degree to which an asset or security can be bought or sold without affecting the asset’s price; fewer trades mean each purchase or sale can have a greater impact on price. With tighter balance sheets, banks have reduced their trading volume. What investment strategies might give investors the best chance to trade their bonds effectively?
At GV, we believe these are valid questions and there are risks in the bond market; however, we remain confident that these risks can be managed effectively through prudent investing. We do not believe Bondmageddon is coming. When we look at history to gain perspective, we discover that bond-markets crashes have actually been relatively mild. In the U.S., the biggest one-year drop in the Global Financial Data extension of Moody’s monthly total return index for 30-year corporate bonds (going back to 1857) was 12.5% for the 12 months ending February 1980. If you compare that to the biggest drop in the stock market, the S&P 500 lost 67.8% in the 12 months ending May 1932; moreover, the S&P 500’s one-year losses have exceeded the bond market’s biggest single loss (12.5%) 23 times since 1900. Source: Robert Shiller, Project Syndicate.
While the above questions are just now becoming mainstream, we have been thinking about the possible impact of these questions on the bond market for some time. Here are few thoughts to consider:
- With attractive risk-adjusted return opportunities harder to find, investors need to have patience and discipline with a defined process to avoid taking on excessive risk even in bonds.
- We believe that investors should be aware of the bonds they own. If they bought long-term bonds in the last few years chasing yield, they should understand the implications of rising rates on long-term bonds which lengthens a portfolio’s duration, or its price sensitivity to changes in rates.
- If investors believe in passive bond investing, they should be aware of the intricacies of trading the passive products in volatile bond markets. An example of this could be seen during the bouts of volatility in high yield credit last year – technical selling in September/October 2014 from outflows in passive strategies like high yield ETFs caused spreads to widen substantially in a short period.
We generally believe that active management remains a prudent strategy for fixed income investors, especially in the current environment, and that active management has the potential to achieve higher returns and greater diversification while providing the desired level of liquidity.
To learn more about GV’s bond investing strategies, contact a GV advisor at www.gvfinancial.com.