Bonds begin to do well again towards the end of the period of rates rising, because inflation should be falling and economic growth slowing, with the potential for a recession to come.
In such a scenario, investors are attracted to the relative safety of bonds in times of market strife.
Exit music
Eren Osman, head of investment management at Arbuthnot Latham, says: “Higher interest rates depress bond prices, as the income offered to bond holders becomes relatively less attractive, compared to income offered as cash on deposit.
"The sensitivity to a change in interest rates is most acute for bonds that pay a low fixed rate coupon and long-dated maturity; hence capital losses seen in government bond markets in 2021 have been particularly significant given that we are exiting a period of ultra-low interest rates."
Inflation concerns combined with tightening job markets have prompted central banks to communicate expectations to normalise interest rates through and beyond 2022.
Osman says while several future interest rate hikes have already been ‘priced-in’ by bond markets, hence recent capital losses, there are sectors within the fixed income complex that offer investors protection from rising interest rates.
Asset-backed securities and mortgages allow for income payments to adjust upwards to account for an increase in interest rates, potentially allowing investors to retain security over the underlying assets.
Andrew Lake, head of fixed income at Mirabaud Asset Management, says the key debate in bond markets right now is between those who believe we are early in the economic cycle, with a sustained period of inflation, economic growth and rate rises to come, and those who believe we may already be at the stage where growth has peaked, that rates are being raised into an economy that is decelerating, and so preempt a recession.
In the case of the former, investors buy bonds with a short date to maturity (short duration), in order to protect the real value of the income. Those who believe we are later in the cycle typically buy government bonds (the lowest-risk asset class) with a long date until maturity.
This is because they believe the interest rate they can get today will look attractive when the recession comes and rates are cut to stimulate economic growth.
Lake says: “If you are in the camp that says we are early cycle, if you are buying short duration, I think you need to be very selective in terms of what you buy. The unwinding of QE was always going to be painful.”
Fahad Hassan, chief investment officer at Albemarle Street Partners, says that while having little exposure to government bonds does not necessarily make sense in a world of higher inflation, they can act as a diversifier, so if the economic environment changes then the government bonds will perform well.
