Are Global Bond Markets Headed for a Day of Reckoning

A Look at How Rising Interest Rates Could Hurt Bonds

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The Threat of Rising Interest Rates to the Global Bond Market

The U.S. Federal Reserve’s Federal Fund Rate target is set to 0.25% to 0.5%, but expectations are rising for a rate hike by the end of 2016. While interest rates have been very low for a long period of time, central bankers will have to eventually raise rates to reward savers and investors that depend on fixed income investments. These higher interest rates could spark an exodus from the bond markets and into riskier assets.

In this article, we will take a closer look at these risks and what investors can do in order to mitigate risk in their portfolios.

Quantifying Interest Rate Risk

There are two important risk factors for investors in the global bond markets to consider, including limited upside potential and downside risk.

Many developed country bonds are trading at record low yields, while the European Union and Japan are flirting with negative rates on their sovereign debt. Investors purchasing negative interest rate bonds are actually paying to own bonds with the hopes that interest rates move even further into negative territory and push prices higher. However, the capital gains potential for these bonds continues to diminish as yields move to new record lows.

The second major risk is that of rising interest rates, which reduce the price of bonds over time. In the U.S., expectations for a Federal Reserve rate hike have been on the rise, which could jeopardize U.S. Treasury and corporate bond prices.

The rest of the developed world may still be a way off from hiking interest rates, but these are important risks that should be considered when buying bonds with lengthy maturities of five years of greater.

Positioning Your Portfolio

There are a few steps that investors can take to limit their exposure to interest rate risk in their bond portfolios and improve risk-adjusted returns.

The first step is to reduce duration in any bond portfolios at risk for a near-term interest rate hike. For instance, U.S. investors may want to consider reducing duration in their portfolios by transitioning into shorter term bonds rather than long-term bonds. Investors may also want to consider diversifying their bond exposure across both government and corporate issuers in order to reduce the risk of decline in any single bond category.

The second step is to avoid negative interest rate bonds and seek out high quality issuers that offer better yields, which can often be found in the corporate sector rather than government bonds. A good approach is to invest in a diversified basket of bonds that offer higher yields in order to reduce absolute risks without resorting to bonds that are lower risk on an individual basis. Many Exchange-Traded Funds, ETFs, provide these kinds of options in an easy-to-trade security.

Popular ETF Options

There are many ETFs that international investors may want to consider in order to reduce risk in their global bond holdings.

U.S. investors may want to consider municipal bond ETFs, like the iShares Muni Bond Index Fund (MUB), or short duration bond funds, like Vanguard Short-Term Bond ETF (BSV).

These funds have less interest rate risk than many other types of bonds and may be attractive alternatives to other U.S. bond classes. Of course, it’s also important to consider the expense ratios of these ETFs before purchasing them.

International investors may want to consider emerging market bond ETFs, like the PowerShares Emerging Market Sovereign Debt ETF (EMB), or corporate bond ETFs, like the SPDR Barclays International Corporate Bond ETF (IBND), as an alternative to traditional government bond funds. Again, it’s also important to consider expense ratios and other risk factors when buying these kinds of bond funds.

The Bottom Line

Record low interest rates have driven global bond markets to record highs over the past several years, but the upside potential for these bonds may be limited given negative interest rates in many developed countries.

Investors may want to consider reducing the duration of U.S. bond holdings and diversifying into higher yielding issues internationally instead of buying into negative interest rate bonds issued by many countries.