A typical novice investor when referring to ‘Bonds’, perceives them as guaranteed income-generating securities. Rightly so, to an extent, fixed income securities in their plainest form return a coupon (interest) for a given nominal amount invested. Yet, credit risk, total return and interest rate risk are crucially important factors that undermine bonds being classified as guaranteed.
Fixed income performance should be measured in the context of total returns rather than interest returns. Fixed income returns are generally split into price and income returns, the sum of which generates total return.
Income return is generally assessed in terms of yield which is a measurement of the total income return of all current and future cash flows, re-invested at differing periodic interest rates, throughout a bond’s lifetime.
Furthermore, a bond’s credit risk incorporates the probability of default by the issuing corporation. Riskier entities generally issue bonds with higher interest rates when seeking funding, as investors require a higher income premium for undertaking added risk.
A bond’s duration (sensitivity to interest rate shifts) is a big determinant of portfolio managers’ investment decisions. Likewise, retail investors should consider duration prior to parking funds into bonds. Duration can significantly impact the level of price return fluctuations from movements in interest rates.
Taking the current fixed income environment as an example, longer dated, investment grade securities are currently the least favoured portfolio constituents, given the rising interest rate environment. Simply put, as interest rates rise, the economy is perceived to be stronger and investors would be more willing to invest in higher interest rate paying securities.
Therefore, given the larger amount of outflows from lower coupon paying bonds, which are typically investment grade, the price fall will be larger to comparably shorter maturity bonds of the same type.
Reason being, as a bond approaches maturity (shorter duration) and the likelihood of receiving back full principal increases, a bond’s price typically converges to the par rate at issuance, hence a price decline would be less significant.
Alternatively, higher coupon paying bonds, typically high yield, sell-off less than their investment grade counterparts as they offer superior returns.
Having said that, an investor with a long-term passive investment horizon with a buy to hold mandate should be able to hold on to his/her investment grade bonds if actively switching to higher returns is not an objective, as long as the credit risk of that instrument is always kept in check throughout the lifetime of the investment.
For fund managers however, the objective is to generate the highest active return possible to the invested client monies, obviously within the strategy, constraints and mandate of a fund.
So yes, currently, the active investor preference is a switch out from higher grade bonds into equities. A rising interest rate environment in the US and tapering talks in the eurozone should benefit equities, which tend to be positively correlated to a strengthening economy.
Notably, financial equities in both the US and eurozone could have significant upside through higher interest rates.
Furthermore, deregulation incentives in the US could add pressure on eurozone regulators to imitate such steps and remove the significant strain on eurozone banks, notably in Italy and Spain, which have been heavily undervalued and pressurised as a result of their significant non-performing loans crisis.
In terms of active fixed income management, not all is gloom. High yield securities still have room for further spread compression, notably within emerging markets where there remains considerable upside value. Emerging markets seem to have potential as a result of the weaker than expected dollar in the current hawkish interest rate environment.
The majority of emerging market debt is denominated in USD, hence weaker than expected appreciation of the USD is a good sign for companies in the sector to regain upside momentum, through lower refinancing costs.
Disclaimer: This article was issued by Mathieu Ganado, Junior 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 Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.