Where to position yourself when equities are in a bull market and fixed income securities are at the end of a 30-year bull run?
Well, theoretically the answers may be straight forward, yet, given weaker than expected economic data in the US, the answers have been left to investors to anticipate where best to remain invested.
Fixed income has come a long way over the past few decades, and has rallied substantially in the past few years as a result of easy money and loose monetary policy measures by global central banks. Europe, the US, Japan and other global powerhouses have all turned to QE in reaching their inflation and growth targets.
Today, in the EU and the US, economic data has improved substantially, so much so that we have already seen the US implement a number of 25bp rate hikes since December 2015. The ECB is at a different point in the economic cycle but has seen positive enough data to have begun tapering its 80 billion euros a month asset purchasing program down to 60 billion euros a month in 2016.
We are now faced with a situation where all the profits accumulated over the years in the Fixed Income space are starting to be eaten up by monetary tightening and higher interest rates if position reduction hasn’t yet been a consideration.
Bond prices tend to move inversely to interest rates. Capital returns, therefore, are at higher risk for a longer duration, low coupon bond issues.
Lower coupon bond issues are typically associated with investment grade ratings. Hence, although the QE trade does not seem to have completely unwound, significant market movements have already affected returns at the longer end of the Investment grade yield curve.
What to do?
Consulting your investment advisor may be beneficial. Accordingly, you can mutually work on reducing long dated Investment grade exposures in favour of Higher yielding fixed income bonds and/or attractive dividend yields in the equity space.
The shift of monies over the past year has clearly been out of bonds into equities. Rightly so, equities in the current bull market are selectively continuing to offer attractive dividend yields.
High yield bond issues also offer attractive returns, obviously, these come at a higher risk, though rate hike scenarios in the Eurozone and the US risk causing price returns offsetting the income returns for the end investor.
If holding Fixed income is your sole objective, there are options to mitigate interest rate risk. Short duration is definitely the best solution. Price movements for Long Duration bonds are stronger than for Shorter Duration bonds.
The coupon effect also affects price movements, where higher interest rates typically seen in high yield issues would cause less of a shift of monies into higher yielding bonds as a result of a central bank interest rate hike when compared to the investment grade counterparts.
The weaker than expected USD and US data has sustained a certain demand for Investment Grade Fixed Income over the past few weeks, yet the longer picture should be kept in mind, and that is a cyclical shift out of bonds into equities as a result of interest rate hikes.
Although equities valuations are not as cheap as they were a year ago, as a result of the Trump trade rally over the past few months, investor opinions are supportive towards a continuation of a bull market, bar any surprises in economic data.
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.