Interest rate risk is real
October and November have been gruelling months for European and US government bonds. The sharp upward moves in yields on government bonds, across all segments of the yield curve, resulted in a marked re-pricing (lower) of bond prices.
True, yields have been anchored at extremely low levels and only a few months ago tested their all-time lows, but it is still fair to say that the moves we have seen caught many unawares. Not so much so in terms of direction but merely the manner (speed and magnitude) at which yields rose.
In Europe, speculation began to emerge in October that the European Central Bank was considering altering the size of its current asset purchase program from the current €80bn a month when it is due to expire in March 2017.
This coupled with a string of encouraging data releases for the single currency region (particularly related to economic growth and most importantly improvements in inflationary data) and statement by a number of ECB officials resulted in a widespread correction/adjustment in Eurozone government bond prices. I wouldn't term the October moves as a sell-off; that came soon after.
In the US, the outcome clearly shaped the US (and Eurozone) government bond market. With his widely talked about pro-business and consumer policies, such as lower taxes and increase in government expenditure, president elect Trump's victory gave markets reason to believe that economic growth and prosperity will remain supported and inflation will accelerate.
This translates into higher expectations of rate hikes by the US Federal Reserve (in an attempt to prevent the economy from overheating) and this caused a significant repricing and selloff in US government bonds as investors shifted their risk profiles into riskier asset classes such as high yield bonds and equities.
A similar pattern was registered in Europe in the aftermath of the US elections in expectations that the Eurozone too could benefit indirectly from the improvement in US data. Clearly both economies are at different crossroads, the US economy is miles ahead, and this is further accentuated by the widening in the spread between the US 10-year Treasury and the 10-year German Bund which increased from 140 basis points to over 200 basis points in just over three months.
The next move by the Federal Reserve next month is priced in with a rate hike expected, but in the Eurozone the situation is still pretty fluid as the Italian referendum and ECB meeting in the first week of December could still cause a string of surprises, in either direction.
Volatility could creep upwards and we could witness yet again some exacerbated moves in Eurozone government bond prices over the next couple of weeks, as yields take cue from the highly disputable as inflationary expectations.
To say that the sovereign bond market has been challenging is an understatement as those familiar with the intricacies of interest rate risk (duration is the technical jargon) can vouch for this. Low coupon and long dated bonds are exposed to greater interest rate risk (have a higher duration) than those bonds which have a higher coupons and whose maturity dates are not excessive. True, bonds trade at yields but could have varying degrees of duration, and this is what effectively drives bond prices higher and determines the magnitudes of such moves.
There are many who argue either in favour or against whether the rotation out of bonds into equities has already started or if the bond bull market is slowly fading away. What is certain is that November gave us a taste of how real and tangible interest rate risk really is, and how investment portfolios should be equipped to withstand any large swings in inflationary expectations which could adversely impact bond valuations.
This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.