To bond or not to bond, that is the question

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30 August 2012 | Having the right exposure to fixed income markets is an important part of any Risk Parity strategy. Clearly, investors are (very) worried about sovereign risk and the viciousness of interest rate cycles. In this paper we will take a closer look and evaluate the implications of interest rate changes on the performance of bonds and Risk Parity strategies. It appears that the impact of rising interest rates is much more limited than you might expect.

Bonds have come a long way

An analysis of government activity clearly shows that while the period before 1985 was characterized by classical Keynesian fiscal policy, the era leading up to today is influenced by monetarism, inflation targeting and the micro-management of interest rates by central banks. In the wake of every recent economic crisis, governments and central banks have produced a wall of liquidity through the rapid lowering of interest rates and the accumulation of debt. The drop in interest rates over the last 30 years has boosted bond returns and fixed income investors have done very well. But there is also a darker side. The lowering of interest rates may have lured governments into giving up on fiscal prudence. BCA Research shows that there has been a tsunami of debt issuance in the last few years and that the overall OECD government debt has risen by a staggering 15trn USD since 2007.

New debt faces increasing resistance from markets as it becomes ever clearer that eventually all the borrowed money will have to be either paid back or subject to default. Most sovereign balance sheets have been pushed to the limit and weak governments have become prey to the financial markets. It seems counterintuitive, but in the future there may even be a shortage of AAA issuers relative to demand as fewer and fewer sovereigns remain “safe“.

Today, as yields are at record lows, there seems to be little room for yields to fall. Most investors therefore think that rates have only one way to go: up. But although this seems to be a convincing conclusion, it is not necessarily true. Interest rates may just as well stay unchanged or decline even further. As the Danish physicist Niels Bohr once said: “It’s tough to make predictions, especially about the future.”