‘Bond refugees’ may be shocked at how much they lose if the market corrects
So called ‘bond refugees’ may be shocked at just how much they will lose if there is a market correction, Matthew Hoggarth, Investment Analyst at Thesis Asset Management, has said.
Hoggarth believes these investors have been forced to increase their risk in order to preserve yields, as the low interest rate environment has forced many them to hold assets they would not normally be comfortable with.
“Fundamentally our view is that both equity and bond markets remain highly valued. This is a frustrating state of affairs,” he said.
“We see risk control as a fundamental function of our asset allocation, and will seek to act counter-cyclically where possible to shield clients’ capital should a downturn occur.”
Furthermore, following the Federal Reserve’s decision to raise interest rates in March, Hoggarth sees the potential for prices in the bond market to drop considerably.
“The greatest asymmetry is in the bond market, where redemption yields are very low. This means that returns are limited in a positive scenario, but capital values could fall substantially in the event of interest rate rises.
The best case scenario we envisage for bonds is the current coupon yield with the potential for a little price uplift. Bonds become more attractive and their prices rise in an era of low interest rates (because they provide an income stream where low interest rates do not) – but UK interest rates really cannot go much lower in an environment where the US is tightening, so the potential for bond price rises is limited.
The negative scenario would be that interest rates rise and bond prices fall, and from current levels the short-term falls could be substantial. As an example, the 1.25% Treasury Gilt 2027 is one of the few that you can currently buy at close to par. The 1.25% income yield is not a great reward when you consider that a rise in yield of only just over 0.13% would result in a capital loss that would wipe a year’s worth of income out. It’s the old cliché of picking pennies up in front of a steamroller. You might get rich that way, but is it really worth the risk?
“While rates are likely to remain low by historical standards, they could rise more than the market expects, especially if western governments manage to achieve the longed-for reflation.”
However, Thesis does see a scenario where investors can protect themselves against such market corrections.
As a result of the imbalance between risk and return, Thesis has reduced its fixed interest allocations and toned down the interest rate sensitivity of its portfolios by introducing greater exposure to floating rate bonds.
“With credit spreads having tightened considerably, we are maintaining a broad spread of bond exposure to provide diversification,” Hoggarth added.