The Perfect Storm

The Effect of a Base Rate rise on Clients with exposure to UK Bonds in their Portfolio

THE PERFECT STORM

The Effect of a Base Rate rise on Clients with exposure to UK Bonds in their Portfolio

Call To Find Out More: +44 (0)1753 867000

Over the past 12 months you will have seen some fund managers moving to shorter duration bond funds as the expectation of interest rate rises in the UK over the medium term have strengthened.

Tavistock Wealth called correctly both the vote to exit the EU and the election of Donald Trump.

Having been involved with the bond markets for many years, like many others, we are now of the view that the UK base rate will be raised a number of times over the medium term, triggering a fall in bond values and a rise in sterling.

In a series of recent CNBC interviews our Chief Investment Officer, Christopher Peel, has explained that we may be on the verge of bond market losses larger than anything we have witnessed in our lifetime.

Other recent press coverage has seen Bob Michele, Head of JP Morgan’s $432bn fixed income business, saying in July 2017:

“The next 18 months are going to be incredibly challenging. I am not an equity investor but I can just imagine how equity investors felt in 1999 during the “dot.com” bubble”.

He goes on to say:

“Right now, central banks are printing money at the rate of $1.5tn per year. That is a lot of money going into bonds. By this time next year, we think this will turn negative”.

The ending of quantative easing may compound the situation by sparking liquidity problems in global bond markets. Additionally, former Federal Reserve Chairman Alan Greenspan said:

“By any measure, real long-term interest rates are much too low and therefore unsustainable. When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices.”

Other recent press coverage has seen Bob Michele, Head of JP Morgan’s $432bn fixed income business, saying in July 2017:

“The next 18 months are going to be incredibly challenging. I am not an equity investor but I can just imagine how equity investors felt in 1999 during the “dot.com” bubble”.

He goes on to say:

“Right now, central banks are printing money at the rate of $1.5tn per year. That is a lot of money going into bonds. By this time next year, we think this will turn negative”.

The ending of quantative easing may compound the situation by sparking liquidity problems in global bond markets. Additionally, former Federal Reserve Chairman Alan Greenspan said:

“By any measure, real long-term interest rates are much too low and therefore unsustainable. When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices.”

Any questions? Email Our Team: Investments@tavistockwealth.com

WHAT WE PREDICT WILL HAPPEN NEXT

WHAT WE PREDICT WILL HAPPEN NEXT

Call To Find Out More: +44 (0)1753 867000

We are of the view that any increase in base rates will seriously affect those clients invested directly into bond funds or in bonds via Lifestyle funds. These clients are typically more cautious and are therefore least likely to be prepared for, or be able to sustain, serious losses.

Why THIS WILL HAPPEN

One of the issues facing the UK bond markets is that yields are low and durations are high. A yield is the return an investor receives should they hold the bond to maturity. Duration is a measure of a bond’s sensitivity to movements in the level of the market.

For example, if a bond has a duration of 5 years, its price will rise 5% for every 1% drop in interest rates. Conversely, its price will fall 5% for every 1% rise in interest rates. In recent years this has worked in favour of most bond investors; falling rates and increasing durations have led to significant capital gains during the bond ‘bubble’.

One of the issues facing the UK bond markets is that yields are low and durations are high. A yield is the return an investor receives should they hold the bond to maturity. Duration is a measure of a bond’s sensitivity to movements in the level of the market.

For example, if a bond has a duration of 5 years, its price will rise 5% for every 1% drop in interest rates. Conversely, its price will fall 5% for every 1% rise in interest rates. In recent years this has worked in favour of most bond investors; falling rates and increasing durations have led to significant capital gains during the bond ‘bubble’.

However, the UK bond markets currently have the following approximate yields to maturity (YTM) and durations:

Turn sideways on mobile to view the table

Any questions? Email Our Team: Investments@tavistockwealth.com

THE IMPACT ON CLIENTS

THE IMPACT ON CLIENTS

Call To Find Out More: +44 (0)1753 867000

It is widely expected that both UK inflation and interest rates will rise in the medium term. To give an idea of the potential losses on the horizon for UK clients investing in UK bonds, we provide an illustrative example below. If we assume that the UK bond allocation within a portfolio comprises 50% Gilts and 50% Sterling Corporate Bonds, this means that from our table above a client’s holding would have an aggregate yield of 2.0% (50% of 1.3% + 50% of 2.7%) and an aggregate portfolio duration of 10.2 years (50% of 11.3 + 50% of 9.0):

Turn sideways on mobile to view the tables

Such holding would perform as follows in the event of a 1% rise in interest rates:

Here clients would suffer a -10.2% loss and with only a 3% yield, even assuming compound returns, it would take at least 3 years to recoup the losses. Very few bond investors would be prepared for a loss of this magnitude. Each further 1% rise in interest rates would cause a further fall of approximately -10.2%. therefore a 3% rise in rates would lead to the following:

Here clients would suffer a staggering -30.5% loss and with only a 5% yield, even assuming compound returns, it would take at least 5.5years to recoup the losses.

These examples are for illustrative purposes only.

Any questions? Email Our Team: Investments@tavistockwealth.com

How to invest in bonds and avoid potential armageddon

How to invest in bonds and avoid potential armageddon

Call To Find Out More: +44 (0)1753 867000

A greater investment in Overseas bond markets. Exposure to the likes of global government, global corporate, global high yield and emerging market local currency bonds can provide better risk/reward opportunities for a bond portfolio at present.

 

A reduced portfolio duration. High quality, short duration corporate and sovereign issuance will significantly protect clients in a rising inflation/rate environment.

These factors enable clients to access highly sophisticated and robust bond allocations that offer the potential to achieve positive real returns, which cash and traditional bond allocations will fail to do over the coming years. Crucially, by investing in these shorter duration, global instruments, clients will have an opportunity to make money in bond markets, rather than lose it…

…provided that their non-UK positions are hedged back to sterling to protect against the anticipated rise in the pound. In the absence of this all of the good work to avoid a problem in the bond markets will simply be undone by exposing the clients to a currency problem. A rise in interest rates, combined with a rise in inflation, is likely to lead to a rally in sterling. Such a raly would cause the (newly increased) overseas bond holdings to decrease in value on account of sterling strengthening against the currencies they are denominated in. This is what we mean by the perfect storm – it is a simultaneous bond and currency crisis.

Any questions? Email Our Team: Investments@tavistockwealth.com

YOU NEED TO TAKE ACTION

YOU NEED TO TAKE ACTION

Call To Find Out More: +44 (0)1753 867000

because your business may well be at risk

Protect Clients

You have a duty of care to treat your customers fairly. Unlike stock market movements, the signs are here of an interest rate increase, and a subsequent rally in GBP. It will disproportionately affect those who looked to take a lower risk with their investments.

Shorten Duration. Invest Overseas. Hedge Exposure.

Protect the Integrity of Your Business

Duration risk and currency hedging are not widely discussed, nor sufficiently understood. Exposing clients to these risks exposes you to potential client complaints, which in turn exposes your business. It’s time to make clients aware of bond and currency risks.

Shorten Duration. Invest Overseas. Hedge Exposure.

WITHOUT ACTION, POTENTIAL LOSSES COULD TAKE YEARS TO RECOUP.

CLIENTS MAY RECOVER. BUSINESS MAY NOT.

Any questions? Email Our Team: Investments@tavistockwealth.com

HOW TO WEATHER THE STORM

HOW TO WEATHER THE STORM

Call To Find Out More: +44 (0)1753 867000

With Revolutionary Thinking

Low average bond duration

Less investment in the UK, greater exposure overseas

Currency hedging the overseas exposure

Protect clients and your business

All interests aligned: clients, business and provider.

This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Tavistock Wealth Limited. Date of data: June 2018