Corporate bonds: why investors’ knee-jerk reaction to rising interest rates could be wrong
As investors face the prospect of the near-40 year bull market in bonds coming to an end, many are questioning the role of bonds in their portfolios. The knee-jerk response of many will be to cut duration. This could prove a mistake.
Our analysis suggests that the effects of rising rates will depend on how much they go up, where the impact falls on the yield curve and how long the investor is prepared to wait. It means that bond investors need not fear gradual interest rate normalisation, or even a mild recession, but should be on guard against a sharp rise in inflation expectations.
The threat posed by rising yields has certainly grown. The duration of the US investment grade corporate bond index has increased steadily over the last 20 years or so. At the same time, the index yield is near a record low at around 3.9%. It now takes just a 0.7% annual rise in yield for price changes to wipe out a whole year’s worth of income.
However, cutting duration may still not be the right response. There are numerous other factors that affect returns, some of which act against each other and can take a while to play out:
- Shape of the yield curve – yield curve shifts are rarely parallel. When short-term yields rise more than long-term yields (a yield curve flattening), a short duration strategy could underperform a longer duration strategy.
- Trade-off between duration and yield – cutting duration when the yield curve is upward sloping requires foregoing some yield. The benefits therefore need to be large enough to compensate for the lost income.
- Trade-off between duration and roll down – roll-down return is the gain arising when a bond’s duration shortens over time. It depends on an upward sloping yield curve and varies greatly at different parts of the curve.
- Credit spreads – corporate bond returns are also driven by credit spreads. Historically, spreads have been negatively correlated with yields, so changes in spreads can wholly or partially offset any move in Treasury yields.
- Timing – if yields rise towards the end of an investment horizon, it leaves less time to realise the benefits of the resulting higher income.
Investors also need to take account of the opportunity cost. Should forecasts prove wrong and yields stay low or fall further, a short duration portfolio will underperform a longer-dated portfolio.
In order to shed light on the interplay of these factors, we conducted a scenario analysis that simulated the returns in various environments (see chart below):
History repeats itself
A flat or even inverted yield curve has been the outcome of the last two interest rate hiking cycles. Overall, the result is not that bad for bondholders. The returns are only marginally worse compared to a situation where yields remain unchanged. In addition, despite having much higher duration, long corporate bonds actually outperform intermediate corporate bonds.
Recession – a surprisingly benign outcome
Although a recession-induced fall in short-term yields would be associated with rising credit spreads, this is generally a reasonable environment for corporate bond investors, thanks to the benefit they gain from falling Treasury yields. Of course, the outcome is dependent on how much the spreads rise, but the extreme spread widening witnessed in 2008 is unlikely to be repeated.
Stagflation – a much more malign outcome
This is the absolute worst outcome for corporate bond investors, with short-term yields rising sharply and the yield curve steepening significantly. It could arise from an inflation shock to which the Fed is slow to react, coupled with a weak economy. In such a stagflationary scenario, investors would likely be hit by losses from both duration and spread widening. Long bonds would suffer significantly and even short-duration intermediate bonds would fail to produce appreciable returns.
We conclude that the threat posed by higher yields to corporate bond returns is not straightforward. It matters which end of the yield curve is most hit by the rise, while what happens to spreads is important in either magnifying or cushioning rate rises. Moreover, each portfolio must be viewed individually, as the investor’s optimal strategy will very much depend on their investment horizon. Please see the full paper for detailed analysis.
These possible yield and spread scenarios should not be taken as forecasts, but simply represent plausible outcomes we have modelled for each set of economic conditions. Source: Schroders, April 2018.
Return forecasts are not a reliable indicator of future performance.
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