As the liquidity taps are increasingly turned off and policymakers turn to fiscal measures, BMO Global Asset Management’s ETF Investment Strategist, Morgane Delledonne, sets out her thoughts for fixed income markets in 2018 and explains why you should consider immunising your bond portfolio.
We have eased into the new year with ‘much of the same’, with an extension of 2017’s economic backdrop, but we do foresee a few differences.
Major central banks continue to normalise monetary policy amid synchronised economic growth, with the Federal Reserve leading the pack.
Reaching capacity spells uncertain inflation
The robust economic momentum coupled with loose monetary conditions is pushing advanced economies towards full capacity. As long as inflation remains contained, central banks are set to gradually increase interest rates toward the long-term policy rate – for the US Fed Funds rate, this currently stands at 2.8%. However, as developed economies converge toward their long-term growth trend, we anticipate that inflation expectations will become increasingly volatile, challenging central banks’ forward guidance.
The US 10-year breakeven rate has surpassed the Federal Reserve’s (Fed’s) inflation target of 2% this month and we believe that an unexpected rise in inflation could spur the Fed’s hawkish proclivities. Any surprise monetary policy announcement or misstep could trigger volatility spikes in financial assets.
Rotating towards fiscal measures
We expect 2018 to be the year of the rotation from monetary stimulus toward fiscal stimulus in an effort to push developed economies outside the ‘liquidity trap’. In the case of a significant increase in major governments’ debt-to-GDP ratios, which are already at record-highs, investors may reassess the sovereign credit risk and seek higher risk premiums.
A shifting US yield curve
The ongoing Fed monetary tightening is translating into an incremental increase of the front-end of the US Treasury yield curve while the long-end of the curve remains broadly stable, i.e. ‘bear flattening’. In addition, a stronger-than-expected increase of the US government deficit in 2018 (the Congressional Budget Office has projected the tax bill will increase the US national deficit by 0.7% of GDP to -2.8% in 2018), mainly resulting from lower tax revenues, could shift the US Treasury yield curve upward, along with other major economy yield curves as global interest rates tend to be highly correlated.
There are bright spots for corporate bond markets…
However, global corporate bonds are likely to benefit from increasing global demand, while US corporates will also benefit from reform. According to business surveys, US corporates are likely to use tax savings for deleveraging and conducting corporate actions, overall improving their credit quality. Besides, we expect coupon returns to contribute the most to corporate bond excess returns in 2018, as spreads are already at multiple-year lows. The tightness of the credit spreads is not surprising nor alarming at this late-stage of the economic cycle as long as economic growth remains strong.
Source: Bloomberg as of 16.01.2018
…but the environment remains challenging for bond investors
The rising interest rate environment is challenging for fixed income investors, as bond prices move inversely to interest rates. In this context, investors with a short-term investment horizon generally shift toward shorter maturity bonds in order to reduce the interest rate risk (i.e. duration ) of their portfolio. Our 1-3 year Global Corporate Bond ETF is one option for conservative short-duration fixed income exposure. While shorter maturity bonds generally have lower sensitivity to an increase in interest rates, they also generally have lower coupon returns than longer-dated bonds and might not fully compensate for inflation.
For longer-term investors, looking for income and diversification, longer-dated bonds generally provide higher coupon rates as well as ‘term premiums’ when yield curves are upward sloping. But, they also have greater capital risk along with greater duration. Overall, duration management is about balancing capital risk and reinvestment risk.
Immunising your bond portfolio against interest rate hikes
Alternatively, investors can use an immunisation strategy to minimise the sensitivity of their bond portfolio to a change in interest rates. Such strategies require a matching of the investment horizon to the average duration of the bond portfolio. In the example below, we illustrate how investors can use bond ETFs to implement this strategy. We have built three hypothetical immunised portfolios using our BMO Barclays Global Corporate Bond ETFs.
Our range of bond ETFs all have the same average credit rating (A-) but differ in the following ways:
|Weighted average coupon (%)||Average maturity (years)||Duration (years)|
Source: BMO Global Asset Management, as of 29 December 2017.
|Bond ETF Portfolio 1||Bond ETF Portfolio 2||Bond ETF Portfolio 3|
|BMO Barclays 1-3 yr Global Corporate Bond ETF||65%||84%||74%|
|BMO Barclays 3-7 yr Global Corporate Bond ETF||35%||0%||18%|
|BMO Barclays 7-10 yr Global Corporate Bond ETF||0%||16%||8%|
|Weighted Average Duration (yrs)||3||3||3|
|Weighted Average Coupon rate||2.4%||2.4%||2.4%|
|Weighted Average Maturity (yrs)||3||3||3|
Source: BMO Global Asset Management, as of 29 December 2017.
All the bond ETF portfolios have the same average duration of 3 years, which matches our hypothetical investment horizon as we estimate the current tightening cycle will terminate in three years. We conducted an analysis where interest rates rise by 0.25% increments over their current level of 2%, up to 4%, to see how these three portfolios would behave in a rising interest rate environment. In this analysis, interest rates were the only variable to see how these three portfolios would behave in a rising interest rate environment.
The results of the analysis were as follows:
We found that the Bond ETF Portfolio 2, which has a greater weight on the long-dated Bond ETF than Portfolio 1 and 3, gives the best returns as interest rates increase. In other words, a bond portfolio with greater convexity or curvature (i.e. convex relationship between price and yield) is less affected by interest rates than a bond with less convexity. Bond ETFs portfolios that include longer duration bond ETFs can outperform in a rising interest rate environment as coupon reinvestment returns have the potential to overcompensate for capital losses.
Bond ETFs can provide some simple relief
We believe that this analysis demonstrates that investors can implement an interest rate immunisation strategy with bond ETFs instead of other securities with various characteristics, which often involves a complicated set of calculations. In addition, to be cost-effective, bond ETFs also provide an additional layer of liquidity allowing investors to quickly adapt to the changing environment.
 Duration measures a bond or bond portfolio’s sensitivity to movements in interest rates; lower duration means lower sensitivity.
Past performance should not be seen as an indication of future performance. The value of investments and income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.
Investing in ETFs involves risk, including risks associated with market volatility, currency rate fluctuations, replication strategies, and changes in composition of the underlying index and assets.
Shares purchased on the secondary market cannot usually be sold directly back to the Fund. Secondary market investors must buy and sell ETF Shares with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. In addition, investors may pay more than the current Net Asset Value per Share when buying ETF Shares and may receive less than the current Net Asset Value per Share when selling them.
The information, opinions estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.