Bond Market Opportunities in a Low Interest Rate World

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Written By
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Written By
Dan Buckley
Dan Buckley is an US-based trader, consultant, and part-time writer with a background in macroeconomics and mathematical finance. He trades and writes about a variety of asset classes, including equities, fixed income, commodities, currencies, and interest rates. As a writer, his goal is to explain trading and finance concepts in levels of detail that could appeal to a range of audiences, from novice traders to those with more experienced backgrounds.

Low interest rates throughout the developed world mean little to no return on cash or bonds. In fact, when the inflation rate exceeds the nominal return on a fixed-rate instrument, your spending power is actually declining.

But there’s still widespread demand for liquid, reliable sources of return. 

Bonds usually less volatile than stocks, often significantly so, given bonds usually have a fixed maturity (as opposed to the theoretically perpetual duration nature of stocks). 

Bonds therefore have value to a lot of portfolios and they have fundamentally different environmental sensitivities from risk assets like stocks.

The inflation question

Inflation is a major risk to fixed income instruments in any environment. 

In a period of massive fiscal and monetary policy stimulus and lots of debt and future IOUs that will need to be increasingly monetized, a structurally higher inflation rate is a real risk.

There’s also the cyclical inflation risks to worry about.

During the Covid-19 period, a sudden jumpstart to economies that came to a sudden stop created various bottlenecks across world economies. 

Price inflation spiked in many industries and countries. As governments stimulated to get economies going again, pent-up business and consumer demand overwhelmed supply chains that had trouble getting products to market.

Even though some of this inflation is transitory, higher prices that prove structurally sticky could drive up nominal wages and create other long-run inflation risks.

That reduces the real yield of fixed-rate investments. 

And with interest rates so low, the duration of financial assets is very long. This means even a mild tightening of monetary policy through rate hikes or tapering can cause a large drop in the prices of financial assets.

This means not only bonds, but also stocks and other types of investments dependent that are on interest rates. 

So, a big part of finding quality fixed income opportunities in a low-rate environment is about finding pockets of the market that are less dependent on interest rates. 

A few areas stick out in this regard:

  • High-yield
  • Emerging markets
  • Convertible debt
  • Mortgages and other securitized assets

If traders’ views on inflation and the path of interest rates and monetary policy widens, this should expect to produce more volatility and more demand to manage portfolio interest rate risk and more need for diversification – i.e., away from risk assets that did well under “easy policy” circumstances to more stable sources of yield.


High-Yield Bonds

High-yield bonds have higher credit risk than government debt and investment-grade corporate credit and compensate investors through that risk with higher yields. 

While high-yield bonds also have interest rate risk, the bulk of their risk tends to be credit-related.

Because developed market bond yields are so low, high-yield is an area that still can provide adequate yield and is therefore one of the most appealing options in fixed income. 

HY bonds, however, won’t do much to diversify the equities part of a portfolio. 

They are still sensitive to growth – doing best in an environment where growth is above expectation – and best when inflation is lower or in line with expectations (preserving their real yield).

Buying lower-quality HY bonds and debt from small issuers is one of the purest forms of reflation trades – they’ll have the strongest gains coming out of a downturn and they tend to benefit most in an improving economy.

However, lower-quality HY debt also faces the highest risk of going bust.

One can select individual bonds or buy them as part of an index or ETF, such as HYG or JNK. 


Emerging-Market Assets for Higher Risk and Reward

Emerging markets struggled coming out of the Covid-19 pandemic given:

a) a lot of the monetary stimulus went to the US and other developed countries, and 

b) these countries significantly lagged in getting their populations vaccinated to get a more normal and sustained pickup in economic activity. 

When compared with the near-zero cash and bond rates in developed markets – and negative returns in real terms – emerging market debt is one way to still get positive returns on bond investments. 

High-yield emerging-market credit may be more attractive than investment-grade debt. The former provides a bigger cushion against rising yields in the developed world.

Opportunity also exists in emerging-market currencies. Central banks in these countries will want to mitigate inflationary pressures by hiking rates, thus bettering yields and increasing demand for the currency (holding all else equal). 

At the same time, traders always need to look at what’s priced in.

If rate hikes are already priced into a currency (looking at its yield curve is an easy way to find this), the central bank will need to follow through by at least this amount.

The current price of something reflects the discounted value. This includes the determination of relative exchange rates.


Mortgages and other securitized products

Housing strength is a positive for mortgages. Securitized products are one way traders can get access to quality fixed income yields. 

US residential credit is one opportunity. The US lacks sufficient housing stock, which dates back to the 2008 housing crisis. 

Yet demand is increasing with:

  • more of the population coming into its prime homebuying years
  • new work-from-home (WFH) dynamics and 
  • interest rates being low

Bonds that are securitized by assets in some sectors may also provide attractive yields. 

These include things like aircraft leases, small business loans, and student loans are common asset-backed securities. 

Benefits of the securitized bond market for traders and investors include their lower bond durations, higher yields, and generally quite high credit fundamentals. 

They also tend to be relatively uncorrelated to other returns streams in a portfolio. This increases their diversification value, which is mathematically important in constructing a good, well-balanced portfolio.


Convertible Bonds as a form of inflation protection

As the economy recovers, the inflation rate generally rises.

Traders recognize we’re in a world where interest rates are so low to the point of having negative real yields and more liabilities are going to have to be monetized over time. Where that leads us in terms of the big picture is a different story.

We can expect this to mean a structurally higher inflation rate and more demand for inflation protection

Most traders in developed markets have extrapolated what they’ve gotten used to during their lifetimes:

  • low interest rates
  • low inflation
  • high deficits
  • a rising to strongly rising stock market

But all traders should think about how their portfolios would perform in a stagflationary environment that would be bad for most stocks and fixed-rate securities.

This is where convertible bonds can come into play.

Convertible debt is corporate bonds that can be converted into equity in a company (common stock or equity shares in some form). 

This is different from other types of fixed income investments. 

They also tend to have shorter duration than other types of bonds. This helps mitigate the risk to their valuations in a rising rate environment. 

In a year like 2021, which saw a rise in bond yields but a rise in the stock market, convertible bonds tend to generally be some of the strongest performing in the fixed income space.

Further reading