Investors shouldn’t over-react to the recent spike in interest rates by bailing out of global bonds, according to Ben Trollip, recently-appointed senior investment consultant at Melville Jessup Weaver (MJW).
In a note published last week, Trollip says while the trend-setting US 10-year Treasury yields have jumped 0.75 per cent since September 30, the move was “not atypical”.
“Some commentators are calling an end to the ‘bond bull market’ (ie that yields will now be in a multi-year upward trend),” he says in the MJW note. “However there are many on the other side of the debate that believe the bond market has overreacted in recent weeks and yields may be due to rally (ie revert downwards).”
Trollip says the bond market has experienced many similar “false dawns” in the years following the global financial crisis (GFC) alone.
He warns that a knee-jerk response to exit long global bonds in favour of cash or short-duration products could come back to bite investors.
The MJW note says dumping global bonds would have at least three disadvantages for NZ investors by:
- removing the ‘tail hedge’ power of longer duration bonds in the face of “unanticipated adverse events” that dampen interest rates;
- reducing diversification; and,
- potentially missing out on the higher projected “running yield” of global bonds compared to cash.
Trollip says investors should remain wary of locking in losses by selling into the short-term volatility seen in the bond market.
“History has shown that while it feels ‘comfortable’ to sell out of sectors that have done poorly, often the correct action is to make the ‘uncomfortable’ choice and retain one’s position,” the note says.
Nonetheless, Trollip says investors could be justified in trimming their exposures to long global bonds given the significant creep upwards in duration in fixed income indices since the GFC.
For example, he says the most common fixed income benchmark, the Barclays Global Aggregate Index, has seen average duration increase from 5.25 years in 2007 to the current 6.75 years.
Duration has climbed up as investors issued longer-term debt to take advantage of suppressed interest rates. Lower interest rates, too, skewed the index by reducing the ‘weight’ of “coupon payments in the duration calculation”, the MJW note says.
“Therefore, there is an argument for considering a reduction in the exposure to global bonds to bring one’s portfolio back into line with the level of duration that it would have had, were indices at their pre-GFC levels,” Trollip says.