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Bonds – an asset class that ‘masks a lot of danger’

21 February 2019

Seven Investment Management (7IM) is warning investors that the chance of a bond catastrophe remains worryingly high, particularly to cautious investors, as interest rate rises are set to continue. 

The Investment Management team at 7IM said it has protected portfolios through holding fewer bonds in recent years as they would rather give up the 1.1% coupon offered by gilts to save investors from potential 5% capital losses.

Terence Moll, chief strategist at 7IM, says: “For a long time at 7IM, we have been talking about the impact that rising interest rates will have on portfolios that are heavily weighted to bonds. The maths is simple and inescapable – a 1% rise in the yield of a 10 year bond results in a (roughly) 10% loss of capital.

He adds the risk is particularly high for cautious portfolios where allocations to bonds are typically higher in order to smooth out bumps in equity returns.

“For cautious investors, a permanent loss of capital is the key thing to avoid – they have less time, and fewer risky assets that can generate gains to compensate.

“But in seeking to avoid equity market volatility, cautious investors may be taking a far greater unseen risk. Interest rate increases haven’t finished, and bonds are still exposed.”

Although in light of the recent volatility, expectations for four rate hikes from the Federal Reserve this year have been reduced following a more dovish tone in January’s FOMC minutes, rates are still on a rising path, Moll adds.

It has taken over two years for the Fed to raise rates by 2% to between 2.5% – which is still much lower than the long-term average of 5%.

Outside the US, interest rates are still incredibly low but they won’t be forever, according to Moll. Also, Europe should begin exiting the extraordinary negative rate environment in a year or two. Japan is increasingly finding that low rates are unsustainable. And there are no large central banks looking to cut rates, as inflation begins to reappear on the scene.

Moll comments: “The global financial crisis wasn’t just about interest rates. The money pumped into global bond markets is in the double digit trillions. Removing it is not going to be without consequences, no matter how gradual.”

As a result, 7IM says it has maintained its underweight position in fixed income, holding exposure only to quality instruments to reduce volatility and as tail-risk protections. These are concentrated in high grade government bonds such as Gilts, US Treasuries, and Japanese and European government bonds.

Moll explains: “If Brexit negotiations go horribly wrong, gilts are likely to see panicked safe-haven flows. In addition, there are a lot of captive buyers, such as insurers and pension funds, that keep demand high.”

Overall, 7IM cautions investors against holding large fixed income exposure in a rising rate environment. “Bonds have been in a bull market for the past 35 years, ever since the high interest rates of the early 1980s started to decline.

“We often hear the comment that ‘interest rates have gone up, and nothing bad has happened to bond markets’. That statement is missing a word – ‘nothing bad has happened to bond markets…yet’.

“So far, that pain hasn’t happened. But that doesn’t mean the risk has vanished.

“We want to avoid the pain for clients in an asset class that may look unthreatening but masks a lot of danger,” Moll adds.

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