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Be careful with bonds in a rising rate environment

Bond investors should adopt a selective approach to portfolio construction as looming U.S. Federal Reserve rate hikes are likely to negatively impact large parts of the fixed income universe.

Bond investors should adopt a selective approach to portfolio construction as looming U.S. Federal Reserve rate hikes are likely to negatively impact large parts of the fixed income universe, according to the Australian Corporate Bond Company (ACBC).

ACBC Co-Founder Richard Murphy explained that bonds and interest rates have an inverse relationship, meaning that when a central bank raises interest rates the capital value of fixed income investments will generally fall.

However, how investors hold bonds is a significant factor in how much they will be impacted as rates rise.

“Holding bonds individually versus holding them in a fund or exchange-traded fund (ETF) results in very different outcomes when rates do rise. You also need to be aware of the duration of bond funds or ETFs. If the fund or ETF holds long-duration bonds, as many do, then the fall in value when rates rise will be quite significant as longer-dated bond prices are increasingly more sensitive to rate changes the longer they get,” Murphy said.

Long-duration bonds are securities with maturity lengths of 10 years and beyond, while short – duration bonds span periods between a few months to 10 years. Australian bond index durations have been steadily increasing year on year since the Global Financial Crisis as more long-dated bonds have been issued.

The market is pricing in an over 70% chance that the U.S. central bank will raise rates for the first time this year in December. At its November meeting, the Federal Open Markets Committee (FOMC) said in its post-meeting statement “the case for an increase in the federal funds rate has continued to strengthen” on the back of encouraging economic activity.

“We are still inclined to the view that the Fed will lift rates in December, subject of course to the data flow and market developments,” said David de Garis, Senior Economist at NAB.

With U.S. rate rises inevitable, the impacts will be felt worldwide, thus Murphy said investors should carefully discern how they invest in fixed income. “Our analysis shows the significant difference duration will have on owning individual bonds versus funds or ETFs,” he said.

“If you are invested in funds or ETFs, you cannot wait for maturity to receive your capital back because funds and ETFs are perpetual. You need to sell your units. But if rates have already gone up and bond prices have fallen, then the loss of capital is locked in unless rates come down again.”

Whereas, holding bonds individually, investors can wait to maturity if rates rise and holders will receive the principal back and the yield they bought the bonds for in the first place.

ACBC issues investments known as exchange-traded bonds or XTBs – ASX-traded securities that provide exposure to individual senior unsecured bonds of major ASX listed companies such as AGL Energy, Sydney Airport and Telstra. The company recently surpassed $100 million in funds under management across its line-up of 48 XTBs.

“While XTBs themselves carry duration risk, two key advantages are: first, investors can hold the XTBs to maturity, and so if rates rise, they avoid the impact of the rate rise because the bond matures at $100. And second, investors can be selective and choose what duration they’d like. In a rising interest rate environment an investor may wish to choose shorter-dated duration securities,” Murphy said.

But it’s important to understand that XTBs carry the same risks as owning bonds including credit, concentration and interest rate risks. In particular, investors should note that investing in one or a small number of XTBs is likely to be more concentrated and may be more expensive than investing in bonds via a fund or ETF. Conversely, as bond funds and ETFs tend to track government bond dominated indexes, investors may be able to earn relatively better returns owning higher yielding corporate bonds individually.