Beat the bond bear market

Bria Murphy considers the potential impact of future interest rate hikes on bond holdings and how investors might protect their pensions from the fallout.

When it comes to plan-ning for retirement, investors generally opt for what they perceive to be a low-risk strategy. In terms of portfolio construction, this typically translates into a sizeable allocation to bonds as bonds are considered low-risk and therefore, ideal for pension funds. However, interest rate hikes could dent the value of bond holdings – and consequently, pension funds – for  unsuspecting investors.

Bonds have consistently proved popular with pension fund investors. In fact, some of the largest bond-holders in the world include pension funds. As an asset class, they are perceived by many to be risk-free and for that reason, it is not uncommon to see pensions with concentrated bond allocations. The perception that bonds are risk-free has become particularly apparent in recent years with the proliferation of ‘lifestyle pension funds’. The majority of pension schemes offer managed lifestyle funds as their default option to new and existing members.

These funds do not take current market conditions into consideration when setting their asset allocation, however. They instead use a formulaic approach to investing by automatically transitioning assets from higher risk equities to lower risk bonds as the investor nears retirement. In some cases, up to 70-80 per cent of your pension could be invested in bonds as you approach retirement. If bond yields rise, as expected, many investors could see the value of their pension pot fall just as they are about to retire.

From an investment perspective, bonds will always play an important role in a well-constructed pension portfolio as they can offer protection in times of crisis. But bonds are not entirely risk-free. If you buy an AAA-rated sovereign bond from a reputable government, the risk that it will not pay a coupon and return your capital is very low. It could therefore be considered a low-risk investment but like a stock, the value of a bond can rise and fall over its lifetime.

Bond prices have an inverse relationship with interest rates. When interest rates rise, bond prices fall and bond yields rise. For example, if you buy a bond today paying a high coupon or yield and interest rates fall tomorrow, the price of that bond will rise as investors are willing to pay more for the higher level of income. The reverse is also true. If you buy a bond today with a low coupon and interest rates rise tomorrow, that bond will no longer be as attractive to investors and its price will fall. The Bond Iceberg graphic on the right depicts this relationship. It illustrates the likely fall in value for bonds of different durations where yields increase by one per cent. For example, a one per cent per annum increase in yields on a 30-year German bond would result in a fall in bond value of 22 per cent.

It is easy to see why bonds have become popular with pension funds in recent years. Bonds have enjoyed one of the longest bull markets in living memory. Never in economic history have interest rates been so low for so long. During the recent financial crisis, central banks across the globe slashed interest rates close to zero and implemented the unorthodox policy of quantitative easing (QE), which essentially created new money. With that new money, central banks primarily bought bonds to urgently inject liquidity into the system. Together, the US Federal Reserve (the Fed), the European Central Bank (ECB), the Bank of England (BoE) and the Bank of Japan are estimated to have created a staggering $10 trillion of new money since the start of the crisis. This flood of money has pushed bond yields down to today’s low levels.

The ECB remains committed to its programme of QE but both the Fed and the BoE look set to raise rates in the not-too-distant future. Although the timing and magnitude of interest rate hikes is uncertain, both banks have been relentless in communicating future rate increases. The primary catalyst for the hike is an improving economic outlook in both countries.

So how is the bond market likely to react to the prospect of higher rates? We need only look back as far as 1994 to get an insight into the likely response. Like today, bond yields were pushed lower by the recession of the early 1990s and inflation was falling. When the outlook turned positive in early 1994, the Fed began to raise interest rates aggressively. Between the first rate rise in February and the end of the year, it raised rates from three per cent to 5.5 per cent. Panic ensued in the bond market. Investors dumped bonds and trillions of dollars was wiped off the global bond market in what has become known as The Great Bond Massacre. In an attempt to avoid a repeat of 1994, it is clear that any rate increase will be well-flagged by central banks. The hope is that pension fund managers will adjust their bond portfolios in an orderly way. While this is likely to stem any sudden large losses in bonds, over the longer term it could have a detrimental impact on the performance of many pensions.

The size of the interest rate impact is unclear but to prepare for a more challenging time ahead, there are three important steps investors can take to limit damage to their pension from rising interest rates.

 

Bria Murphy ACA is an Equity Analyst at Davy Private Clients.