You have probably heard the phrase that interest rates and bond prices move in opposite directions. That is, as interest rates rise bond prices are expected to fall and vice versa. However, since the start of 2021 we have observed a steady rise in international rates, yet corporate bond prices continue to increase. How can this be? Before we try to address this apparent paradox, let us explore the reasons behind the current rate moves (particularly in the US) and whether this should be cause for serious concern for bond investors. We will also look at where we can still find lucrative investment opportunities.
RATES ARE RISING FOR GOOD REASONS
Global interest rates tumbled to record lows last year as economies sank into severe recessions due to the coronavirus pandemic. But as rates fell to record lows so too did many asset prices including many bonds. However, aided by unprecedent support from central banks and governments, economies began to gradually recover. So naturally in response, global interest rates have been adjusting modestly upwards to reflect a “brighter” looking global economy especially given the discovery and roll-out of effective vaccines.
Rates in the US, however, have been moving up at a much faster pace on inflation fears which are largely being driven by a swifter than previously anticipated return of the economy to its pre-pandemic level. The faster pace of recovery is being aided by improving vaccination efforts as well as by an additional round of large fiscal stimulus from the Administration of President Joe Biden.
Growth forecasts for 2021 are being ratcheted up from a range of four to six per cent to within a range of six – eight per cent. The new US Treasury Secretary Janet Yellen also recently chimed in on the debate saying that the US economy can get back to its pre-COVID-19 level as soon as 2022 if Biden’s US$1.9-trilliion fiscal package gets approved by Congress. So as the economy gains traction and inflation expectations elevate, anxiety has been building that less support (liquidity and low interest rates) will be needed from the US Federal Reserve Bank (Fed) thus causing a relatively more profound rise in US Government rates.
SHOULD INVESTORS BE CONCERNED ABOUT RATES RISING IN THE US?
Higher rates do not mean high rates
Investors should not be overly concerned about the recent spike in US interest rates. Longer-term rates (example, 10 year & 30 year) have risen, but the Fed policy rate has not and is not expected to for quite some time. In fact, the Fed chairman recently committed to staying the course on its near zero per cent policy rate as well as its US$120 billion monthly purchases of bonds from the market. The Fed maintains the view that, despite significant improvements in the economy and labour market since the depth of the COVID-19 pandemic, a fair amount of ‘slack’ remains which will require considerable time to remedy.
Additionally, the Fed is also not concerned about inflation and is even prepared to let the economy “overheat” for a while to get its average inflation target up to two per cent which it has struggled to achieve for well over a decade now. The Fed therefore has no plans to raise its policy rates until at least 2023 and will likely intervene if long-term rate increases continue for too long. Besides, even with the recent run-up in rates, longer term rates are still near historic lows and have basically returned to pre- COVID-19 levels. Higher rates do not therefore translate into high rates especially if one considers that the current US 10-year treasury is around 1.4 per cent which is well below the historically averaged of about six per cent. We are still in an environment of low interest even with recent upward moves.
Now back to the bond
So why does the inverse relationship between interest rates and bond prices no longer appear to hold? The truth is: the actual relationship is between bond prices and bond yields. As the price of a bond increases its yield falls and vice versa. The yield on a corporate bond can simply be decomposed into two parts. One portion indicating the benchmark rate (or government bond yield) for the relevant tenor and the other part reflects the credit spread or default risk of the issuer. For example, a 10-year corporate bond with a yield of 6.4 per cent reflects a benchmark rate of 1.4 per cent (current 10-year US treasury yield) and credit spread of five per cent or 500 basis points. Whereas benchmark rates have been rising recently, corporate credit spreads continue to fall. As previously mentioned, benchmark rates or government bond yields have been adjusting to reflect a rosier outlook for economies; but so too has corporate credit spreads. Most credit spreads (which ballooned last year at the onset of the pandemic) are currently falling more rapidly than benchmark rates are rising, resulting in lower corporate bond yields and higher corporate bond prices. So, what appears to be a paradox is not the case as the correct relationship is bond prices and bond yields move in opposite directions.
Are there still attractive bond investment opportunities?
Yes. Many bond prices have improved from the so-called reopening trade” but opportunities still remain in sectors or industries that are either in the embryonic stages of their recovery or yet to begin. The retail and energy sectors, for instance, could be considered for additional upside potential as vaccine rol-louts and additional US Government stimulus facilitate further recovery. Similarly, the travel and entertainment industries should also benefit from ongoing vaccinations and ultimately, a corresponding boom in economic activity for these industries. However, all bonds are not created equal so consult with an experienced financial practitioner to assist with your bond buying decisions.
Eugene Stanley is the VP, Fixed Income & Foreign Exchange at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: firstname.lastname@example.org