Breaking Down Bonds in a Low Rate Environment

February 2017 - Transcript

What has been the main driver of interest rates moving higher?

Catherine Philogène:

Over the last number of quarters, the market was anticipating that the U.S. Federal Reserve would raise its overnight interest rate, and that would've been on the back of stronger economic growth and higher inflation expectations. This was further amplified when Donald Trump was elected president of the United States on the promise of tax cuts and increased fiscal spending. Not only did we see short-term rates rise, but so too did longer-term rates such as the U.S. 10-year Treasury Bond, and as a result bonds across the spectrum sold off.

What is expected if rates continue to rise?

Catherine Philogène:

I would say that depends, because different bonds react differently to rising rates. When rates rise, initially you'll see bond prices fall as those bonds readjust to those higher yield levels, and as new bonds come to market they'll be issued at those new higher rates. As an investor who's receiving coupons from those bonds, you are likely to reinvest them at higher rates. Let's take, for example, government bonds. When rates rise, they tend to be a bit more sensitive to changes in interest rates, whereas high yield and emerging market bonds tend to be less sensitive owing to the higher coupons that are paid on those bonds, and those higher coupons can actually help to offset some of the losses that you might experience in your bonds when rates rise. Although it may seem uncomfortable at first, investors will actually benefit from those higher rates.

Why are high-yield and emerging market bonds typically less sensitive to rate changes?

Catherine Philogène:

We can think about high yield bonds and emerging market bonds as being made up of two different components. The first one would be the yield on a government bond of a similar maturity, and a spread which is the compensation that an investor receives for the additional risk that they're taking on, such as the issuer defaulting on its debt. Typically what we see when rates rise, the economy is moving along, corporate profits are strong and investor risk appetite is high, and so as government bond yields increase those spreads tend to narrow, and that narrowing of spreads helps to offset some of that volatility. In addition, high yield and emerging market bonds do pay those higher coupons which essentially help to offset those losses.

What steps can a fixed-income investor take to protect their portfolio?

Catherine Philogène:

There are a number of steps that an investor can take in order to protect their portfolio. The first is considering one's time horizon. So, when you think about the amount of time that you need to meet your obligations, that can be a very important consideration. For instance, if you have a time horizon of seven to 10 years, then a core bond fund might be an appropriate investment, whereas a short-term bond might be more appropriate if you have needs for that capital in the next couple of years. Another important point is diversification, not only at the total portfolio level but also within the fixed-income component, and it's important to diversify within a variety of different bonds because, for example, government bonds may move in different direction to emerging market or high yield bonds, and those high yield or emerging market bonds offer higher coupons which can help to cushion some of that volatility.