Join our community of smart investors

Protect your bond portfolio

The market can quibble about the details, but the only way interest rates are going over the long term is up, in which case securing your fixed income portfolio against a rate shock is a real priority
April 24, 2014

There have been at least two by-products from the financial crash that will determine how bond investors review their portfolios over the next few years. The first is that any lefty playwright worth their salt is churning out fin de siècle works about the end of capitalism, in which case stick to 'Phantom of the Opera' or 'Gilbert & Sullivan' if you want an untroubled night on the town. The second is that the future direction of interest rates has become an almost over-wheening obsession among market observers, with the debate falling broadly into two polarised camps - we might call them the interest rate versus the inflation school. Both are significant risks to bond prices, but hopefully by diversifying your portfolio and using some simple asset management techniques, private investors can protect their bond capital from the very worst-case scenarios.

In some ways, obsessing over whether the Bank of England is going to raise base rates, with a knock-on effect for a range of benchmark indices, is pointlessly academic. Rates are going up from 0.5 per cent, it is as simple as that. Yet it might not be as fast as many people first thought, with the relative strength of sovereign bond prices this year an obvious example - there have been sudden falls in bond yields driven by risk-off movements in equity prices. For example, long-dated gilt contracts have settled down at 2.5 per cent, when many thought a level of 3 per cent, or more, would be a more appropriate yield for the year. Perhaps it was naive to think that last year's rise in the stock market would translate into further yield gains; Russia's assertiveness in the Crimea demonstrates that the financial system is still fragile enough to respond badly to unforeseen international events, which is why it is never a bad idea to permanently hold gilts as a safety valve in your portfolio. Perhaps we might call this the 'Russian Put(in)'...

In fact, it is not the level of the base rate that concerns bond investors, but what might be a permanently changed perception of risk brought about by the 2008 crisis. David Miles, a member of the Bank of England's powerful monetary policy committee, put it like this in a recent speech: "People who might once have thought of these as one-in-a-100-year extreme events might now think of them as one in 50 years, or even one in 25." What Mr Miles is getting at is something that bond investors have known for some time: risk aversion has reduced the return on 'safe assets' by an average of 2.5 percentage points over the past five years, with little sign based on forward contracts that this will change soon. In basic terms, this reflects the bond market's view that the interest rates are unlikely to rise beyond 3 per cent for years to come. In the meantime, it is the prospect of a gently attritional rise in yields that means bond investors will have to be far more active this year in order to stay on top.

Diversifying risk and staying safe

Of course, volatility - and the possibility of a sudden swing back to risk-on mode - means that bond investors can be exposed to potential losses, as happened in 2013. However, these risks can be minimised by following a few simple rules. Canaccord Genuity bond expert Mark Glowrey believes that investors have to follow a five-step approach in order to safeguard their bond portfolios on current market conditions.

1) Avoid longer-dated bonds

The problem with longer-dated bonds is the greater 'duration risk' associated with them. For example, long-dated gilts are often a barometer for how much investment risk fund managers are prepared to tolerate, and these will therefore be far more sensitive to market sentiment than shorter-dated equivalent bonds. The exception here will be higher-yielding bonds with longer dates, as the defining factor here becomes credit risk rather than duration or maturity.

2) Get a ladder

A relatively simple, if perhaps time-consuming, portfolio management strategy is to use a 'ladder' structure to minimise the risk from rising rates. Simply put, it means an annual rotation of capital from expired bonds that is then reinvested in new issues. The point of this is that as rates rise, the coupons on bonds will start to reflect this, so by layering the portfolio, the average return will rise over time and meet the challenge posed by rising rates in an orderly fashion.

3) Floating rate notes

Floating rate notes (FRN) are a special asset class within the bond market which has a payout linked to movements in the base rate. Generally, these are accessible only to institutional fund managers, but there are a few FRNs available to private investors. However, governments are also getting in on the act. The US Treasury held its first successful FRN auction in January this year, raising over $15bn (£8.9bn) to finance its gargantuan balance sheet. The FRN market is currently small with available issues totally around 22 per cent of the currently available bonds on the market and only about 4 per cent of the total tradeable volume. However, this may soon change (see case study).

4) Use ETFs

One of the unconventional methods is to use futures on inverse ETFs to effectively place short positions on the future direction of the bond market. These should allow you to short the price of bonds over a given time, but market timing is essential. Such trades have a natural carrying cost in a market where the forecast yield curve is moving up steeply, but where the ultimate timings of the price correction is uncertain, so the trade could potentially run against you unless you call the entry point correctly. Whether such ETFs are simply too artificial to be much use to private investors is a moot point, but they are certainly worth investigating.

5) Buy linkers

Despite the debate over rising rates being a slightly academic affair, investors will need to take a view on whether inflation is playing a role in pushing up rates. For example, if this scenario is correct, then snapping up on a few index-linked bonds is a useful way of hedging against both rising rates and inflation. For some of the corporate linkers, returns have been around 1.3 per cent after taking inflation into account. Admittedly, this sounds unexciting, but is at least something to hold if inflation starts to move upwards again, although at the moment, eurozone deflation is actually the greater risk, while UK inflation has fallen to its lowest level in years.

Case study: Impala bonds

South African bank Investec has been busy marketing a new type of floating rate note to retail investors over the past few months that is designed to address the shortage of such instruments available to private investors. The usual caveats about marketing apply, but Investec's initiative, the so-called Impala FRNs issued in association, and on behalf, of the LSE, Barclays and Scottish Widows, do reveal a trend in the market. The basic point is that an FRN is exposed to credit spreads, rather than the underlying base rate, and the growing popularity of the asset class is undeniable. Investec believes that about half new FRNs (72) were issued in 2013 alone. Over 80 per cent of the issuers are financial companies of some description and the vast majority are of short duration - ie, three years or less. This year alone, there have been 17 issues, mostly aimed at the institutional bond market.

The unusual feature of Impala bonds is that Investec takes an existing bond and recycles it into a new single bond. This now carries a variable coupon that takes account of changes in the underlying base rate. For example, the Scottish Widows 5.5 per cent 2023 bond is effectively converted into a new issue by changing the coupon from an annual payment of 5.5 per cent to a quarterly one of Libor plus 2.9 per cent. In order to achieve this, Investec executes a long-dated swap on the bonds, with the investor still holding the credit risk of the underlying instrument, but with the coupon now directed towards changes in credit spreads. The other advantage is that it becomes slightly less risky to invest in longer-dated bonds that have been converted in such a way. The hybrid nature of the bond does leave it open to charges of being overly synthetic, but the returns in comparison with the original bond are undeniable. For example, the LSE Impala bond issued in 2012 has achieved a total return of 15 per cent since it launch. That compares well with the underlying LSE 4.75 per cent 2021, which posted a total return of 10.9 per cent over the same period..

Managing FRNs within a portfolio looks similar to the ladder structure that can be used for traditional bonds. Investec believes that a sample portfolio of FRNs of differing maturity will deliver an average return of 5.1 per cent based on current Libor expectations. This is roughly comparable with a similar ladder portfolio of fixed coupon bonds, but without the added risk of interest rate-induced falls in capital values. Investec markets the Impala FRNs on its books as being available in investor-friendly increments of between £1 and £1,000 - which means that many highly-rated bonds that trade in much larger minimum denominations are brought within the reach of private investors. The bonds are fully tradeable on the London Stock Exchange.