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Declining yields for corporate bonds have created the potential for a ‘bond bubble’ under which a rising interest rate scenario could result in significant losses for fixed-income investors, according to a Fitch Ratings study.
The persistence of abnormally low interest rates – and the inevitable reversion to higher levels – is an issue with many dimensions, affecting financial markets, credit conditions, and economic growth.
To provide context to the interest-rate-risk portion of the ‘bond bubble,’ Fitch analysed the potential losses on a hypothetical yet representative BBB-rated US corporate bond under a various scenarios.
Under one Fitch scenario, a typical investment-grade US corporate bond (i.e. BBB, 10-year maturity) could lose 15% of its market value if interest rates were to rise to early-2011 levels (a 200 basis point rise). Under the same scenario, a longer duration bond (e.g. 30 years) could experience a 25% valuation loss.
The timing, pace, and magnitude of future rate increases is critical to how these risks play out. Monetary policy will likely remain accommodative for the next several years, reducing the near-term likelihood of a rate increase. However, a continuation of low rates could exacerbate the ultimate risks to investors, since over time a larger share of portfolios would consist of lower-coupon securities.
So how should investors handle this? Fitch doesn’t say. One option, however, is to get out of bonds altogether. But, considering the diversification role bonds play and the income they offer, this is not entirely sensible or indeed practicable for many investors.
A more moderate response would be to focus on shorter-duration bonds, which are less sensitive to interest rate rises. In the US, NYSE-listed exchange-traded funds (ETFs) such as the Vanguard Short-Term Corporate Bond ETF (VCSH), the SPDR Barclays Short Term Corporate Bond ETF (SCPB) and iShares 1-3 Year Credit Bond ETF (CSJ) could be appropriate, as they offer the yield pick-up associated with corporate credit while targeting the short-maturity (and thus less interest-rate sensitive) end of the yield curve.
For investors who are reluctant to give up yield and are comfortable taking on more credit risk, short-duration high-yield bond ETFs could be the answer. Options here include the SPDR Barclays Short Term High Yield Bond ETF (SJNK) and the Pimco 0-5 Year High Yield Corporate Bond Index ETF (HYS).
Similarly, investors based in the UK and Europe might want to consider the iShares Markit iBoxx £ Corporate Bond 1-5 ETF (IS15) or the iShares Barclays Euro Corporate Bond 1-5 ETF (SE15) listed on the London Stock Exchange. These funds invest in investment-grade corporate bonds with a maturity between one and five years. And for those investors happy to assume some extra credit risk, the Pimco Short-Term High Yield Corporate Bond Index Source ETF (STHY) could be worth a look. This fund invests in US high-yield bonds with a maturity of less than fives years, thereby offering a decent yield with lower interest-rate risk.
UK and European investors could also consider the innovative iShares Barclays Capital Euro Corporate Bond Interest Rate Hedged ETF (IRCP), a London and Deutsche Börse-listed fund that offers physical corporate bond exposure with mitigated interest rate risk. The fund protects against rising interest rates by hedging out the inherent interest-rate risk in euro corporate bonds by using German government bond futures. The hedging methodology consists of selling German government bond futures contracts in order to target a portfolio duration of zero. Essentially, the short position in German government bond futures contracts would profit from falling bond prices, a consequence of rising interest rates, offsetting capital gain losses from the underlying corporate bonds.
For more adventurous investors, the inevitable reversion to higher rates could represent an exciting trading opportunity. Leveraged inverse bond ETFs, such as the NYSE-listed Direxion Daily 20+ Year Treasury Bear 3X Shares ETF (TMV), the ProShares UltraPro Short 20+ Year Treasury ETF (TTT) and the London-listed db X-trackers US Treasuries Double Short Daily ETF (XUDS), provide an aggressive short-term vehicle to potentially capitalise on rising rates. A word of warning, though, these products should only be used by sophisticated and experienced investors.