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A rate hike and its impact on the bond market

Undoubtedly, fixed income market participants are now concerned about the impact of a possible rate hike by the Federal Reserve (Fed) on their dollar denominated allocation. The situation in Europe surely fails to mirror image the latter preposition based on the fact that inflation growth expectation are still way below the European Central Bank’s target level of two per cent, making the probability of a rate hike a non-event.

In the U.S. the sustained economic figures (in addition to the jobs growth) and now also the uptick in wage growth, are offering the Fed more comfort for the second rate hike. The usual voting committee rate hike preachers are now more and more expressing their strong views of one rate hike this year (the first hike was in December 2015). Investors started to pricing-in a rate hike in the U.S. as the probability of a hike now increased to 57.4 per cent as opposed to the 35.7 per cent recorded in the first week of August.

Theoretically, the impact on the fixed-income market is primarily based on two major prepositions (apart from other considerations), the ‘coupon effect’ and the ‘maturity effect’. In theoretical terms, a rate hike negatively impacts the bond market, as the rate at which the series of cash flows are discounted increased, which in turn lowers the bond’s price. Thus some form of weakening in the fixed income market is warranted once the Fed opts for such move.

That said there more to that and the interesting part is the magnitude of the impact. Looking at the ‘coupon effect’, the higher the coupon the lower the impact. The reasoning is based on the fact that as interest rates increase, investors will fetch higher returns and sell their low coupon holdings and shift towards higher return positions. On the contrary, the magnitude on low coupon issues will larger than the former.

Likewise, looking at the ‘maturity effect’, the longer the maturity the larger the negative impact on price. Here the reasoning is also based on the fact that longer dated issues are more prone to possible economic cycle risks. The ultimate result is downward pressure on price, primarily also on lower coupon issues, as investors are not getting paid in terms of risk-adjusted returns.

To sum-up, theoretically higher coupon bonds with a medium term duration should be less impacted, while lower coupon bonds with a longer duration will be hit remarkably.

However, the question I pose going forward is whether this time round the usual market sentiment will prevail. As opposed to the past predictable markets based on historical past events, nowadays markets are far from predictable and this makes life much more difficult for financial professionals to allocate assets efficiently. My view is that global circumstances today in terms of economic growth are still harshly weak, which in turn led major Central Banks to further easing, primarily in Europe which in turn pushed yields towards record lows.

The ridiculous low yielding bonds in Europe led to a massive shift into US-issued bonds and hard currency denominated emerging market bonds. This is being reflective in the remarkable performance within the said asset classes, 14.8 per cent and 15.4 per cent respectively on a year-to-date basis. Thus in all fairness I find it quite difficult seeing investors pulling out of high yielding debt which are still offering favorable coupons, as reallocation of proceeds at such attractive carry positions are unavailable.

My conclusion on a rate hike in the US is as follows. I expect at least one rate hike this year that will most likely be announced in the Fed’s December meeting. Secondly, although theoretically a rate would bring about a correction in the bond market, I do not expect this to happen (at least on the announcement of the hike) for the simple reason that the yield on US bonds remains more attractive at current levels than that of European bonds.

Notwithstanding the uncertainty ahead, niche opportunities still exist. So let’s be prudent, but at the same time enjoy the beauty of the nowadays unpredictable investment world.

Disclaimer: This article was issued by Jordan Portelli, 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. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.

 

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