On May 8, the head of the US central bank warned of the dangers posed by an extended period of low interest rates.

Key points

  • Janet Yellen warns investors being tempted into a "reach for yield", citing the rapid growth in the issuance of leveraged loans and high-yield bonds.
  • High-yield debt prices plunge, cash withdrawn from exchange-traded and mutual funds at a record pace.
  • When rates do rise there is a risk of a repeat of the turmoil of 1994.
  • ‘Absolute-return’ funds could come into their own, aiming to deliver steady returns regardless of the investment climate by employing a diverse range of strategies.

Yellen warns investors

In a signal that financial markets are becoming excessively optimistic, Federal Reserve (Fed) Chair Janet Yellen warned investors were being tempted into a "reach for yield". To illustrate her point she cited the rapid growth in the issuance of leveraged loans and high-yield bonds, as well as a general loosening of underwriting standards.

Debt price plunge

Despite voicing similar concerns on several occasions in the intervening period, it wasn’t until July 16 that markets finally began to take heed. Over the following two weeks, high-yield debt prices plunged and cash withdrawn from exchange-traded and mutual funds at a record pace – especially in the US. The sell-off appears to have been exacerbated by major investment banks unwilling to absorb the excess supply, due to sustained pressure from regulators to shrink their balance sheets.

Lessons to be learnt

Other types of fixed-income assets, including higher-grade corporate bonds, have emerged relatively unscathed. So if nothing else, the reaction to Yellen’s comments has demonstrated the benefits of holding a diversified portfolio of bonds. But arguably there are even bigger lessons to be learned.

In the past, the reaction of financial markets to the start of each of the last three US rate-hike cycles (February 1994, July 1999 and July 2004) was determined in part by how well the shift in policy had been communicated.

Equities v bonds

In all three instances equities fell quite sharply initially. But within a year they were higher than they had been prior to the first rate rise, with investors focusing on a strengthening US economy. By contrast, bonds fell in the first two cases while they actually rose in 2004. It seems likely this difference is partly explained by the fact that the 2004 hiking cycle was well telegraphed and deliberately incremental in nature.

Warnings may not be enough

The high-yield bond market’s reaction to Yellen’s recent remarks, plus last summer’s plunge in emerging-market assets when the Fed warned it planned to rein in bond purchases, suggests that when rates do rise there is a risk of a repeat of the turmoil of 1994. While the US central bank has tried to give investors ample warning of impending changes in monetary policy, it appears that may not be enough to prevent a violent market response – not least because we are approaching the end of an unprecedented policy easing experiment.

The danger of unwinding trades

The era of record-low interest rates has spawned a huge increase in the number of investors looking to borrow cash – in US dollars and other currencies – to invest in higher yielding assets or currencies. By the time US rates do eventually rise, it is logical to expect investors will have begun to unwind many of these trades. As recent events illustrate, the risk is that they do so in a disorderly manner.

Vulnerable assets

In light of this danger, we believe investors should first and foremost be wary of those assets that have been the biggest beneficiaries of these ‘carry trades’ in recent years. Some emerging-market corporate debt denominated in ‘hard’ currencies may suffer disproportionately when rates rise. The cost of borrowing to fund bond portfolios may rise, while the value of the assets held could drop sharply. Other asset classes are likely to struggle too. ‘Peripheral’ euro zone government bonds, which have enjoyed strong returns in recent years, could be vulnerable. So too higher-yielding currencies such as the Australian and Canadian dollars.

In this environment, ‘absolute-return’ funds could come into their own. These funds aim to deliver steady returns regardless of the investment climate by employing a diverse range of strategies

Stewart Robertson

Senior Economist (UK and Europe)

Safe haven currencies

By contrast currencies such as the US dollar, Swiss franc and Japanese yen, which have been used to fund many of these carry trades, stand to gain. And within fixed income, a number of areas should perform reasonably. For instance, short-duration corporate bonds ought to weather an eventual hike in interest rates comparatively well, with default rates likely to remain low – for the next few years at least. Company balance sheets are already in fairly healthy shape. And global economic output should continue to expand for the next few years, albeit at a moderate rate, boosting company profits and further easing the burden of debt repayments. 

Where else to look

Other categories of fixed income less sensitive to interest rates, such as convertibles and bank loans, should form a part of a diverse fixed-income portfolio. And euro-denominated corporate bonds are likely to outperform, given the likelihood monetary policy within the euro zone will stay loose for some time yet.

Heads you win, tails you win

In this environment, ‘absolute-return’ funds could come into their own. These funds aim to deliver steady returns regardless of the investment climate by employing a diverse range of strategies – some of which should do well in times of increased risk aversion and others in times of rising risk appetite. In doing so they offer potential returns which are uncorrelated to traditional ‘long-only’ fixed-income funds, another obvious advantage.

Multi-strategy fixed income

Our multi-strategy vehicle launched in July incorporates a range of fixed-income strategies. Together these strategies should enable the portfolio to withstand a far wider variety of investment climates than investment into any single fixed income asset-class.

Three complementary strategies

The first strategy looks to benefit from our view that Australian interest rates are likely to fall towards the international average, earning a positive rate of return even if interest rates don’t change. The second should profit from a rise in UK long-term interest rates. And the third, focused on the Italian yield curve, is looking to benefit from our opinion that European interest rates will stay low for longer than the market expects. 

Diversified away from Europe

At the same time, the fund offers some insurance against a surprise rise in interest rates and a rapid unwinding of carry trades. It is is exposed to South Korean bonds, reflecting the investment managers’ desire to be long of fixed-income assets overall. This position simultaneously diversifies some of the fund’s fixed income exposure away from Europe.

Deal in absolutes

The high-yield market’s reaction to Yellen’s remarks has provided us with a timely reminder that the “reach for yield” will not last indefinitely. US rates look very likely to rise by next spring. Given the risks posed by reduced liquidity in secondary markets, it seems many investors may soon want to start planning their exit strategies. But not all fixed-income assets will suffer simultaneously. And absolute-return products could have an important role to play in helping shield investors from some of the pain caused by tighter policy.

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