Hunter Investments chief, Tony Hildyard, has warned investors could dent long-term return prospects by dumping bonds to counter fears of rising interest rates.
Hildyard said current expectations of higher interest rates has sparked misguided calls from many quarters to sell-down bond holdings in an effort to ward off capital losses.
However, he says in a new analysis that while rate hikes could be further off than many anticipated, moving out of fixed income ahead of such a scenario into “riskier assets is likely to exacerbate rather than ameliorate any losses”.
“There seems to be some misconception that ‘bonds’ operate in isolation from other asset classes and that you can hide from rising interest rates in other asset classes,” Hildyard says.
“This is not true, bond yields are generally instrumental in the pricing of other assets and you could easily make a case that interest rates have been the main driver of returns in equity markets over the last 10 years. Rising interest rates will see share markets repriced too but, unlike bonds, shares do not mature and investors will need to wait for an economic or company growth to recover any losses.”
Furthermore, he says in an era of gradual interest rate increases – the most likely outcome if, or when, central banks tighten monetary policies – bond investors can benefit from the transition over time.
“Rising interest rates, while hurting bond prices in the short term, actually improve long-term return outcomes as cash flows (principal and interest payments) are reinvested at higher rates,” Hildyard says.
Moreover, he says bonds retain their traditional qualities as income-supplier, portfolio diversifier and defensive cushion even with rates mired close to zero.
But fixed income portfolios require active management, especially of credit exposure, to minimise any capital losses and to take advantage of yield-enhancing opportunities, Hildyard said.
With concerns about rising interest rates now firmly on the agenda, he says investors should take extreme care before jettisoning bonds as almost no other asset class could provide similar ballast.
“The exception, perhaps, is ‘cash’ but this can mean investors earn a very low interest rate, even negative interest rate, while they wait for bond rates to peak,” Hildyard says. “Currently, cash rates are well below the rate of inflation so, in real terms, the value of your investment is declining while you wait.”
If investors are truly worried about the impact of higher rates on their portfolios, he says they should:
- accept that all asset classes will be affected;
- create a well-diversified portfolio with many different sources of risk and return;
- tilt portfolios towards high-quality borrowers and shares to avoid the risk of default and permanent loss of capital; and,
- have adequate liquidity to minimise the need to sell assets when prices are depressed.
The Wellington-headquartered Hunter manages over $1 billion on behalf of institutional, wholesale and retail investors – mostly in an active global fixed income portfolio overseen by PIMCO.