A fundamental principle of bond investing is that market interest rates and bond prices generally move in opposite directions. When market interest rates rise, prices of fixed-rate bonds fall. This is known as interest rate risk. Maturity can also affect interest rate risk. The longer the bond’s maturity, the greater the risk that the bond’s value could be impacted by changing interest rates prior to maturity, which may have a negative effect on the price of the bond.
Central banks make interest-rate adjustments to keep inflation within a target range for the health of economic activities or cap the interest rate concurrently with economic growth to safeguard economic momentum. Ultra-loose central bank monetary policies have driven bond yields to all-time lows. Ten-year yields have been declining for most of this decade, with German borrowing costs dipping below zero for the first time just before the middle of this year. However since July 2016, a reverse in this trend has occurred. The yield on US government bonds with 10 years to mature rose by approximately 1% and suffered a price decline of almost 8%. This has happened for a number of reasons.
Firstly, the prospect of higher inflation, which erodes future bond income, typically drives yields higher. Yields began to rise in July following the release of strong results for US non-farm payrolls. This recovery in employment growth supported the view that a rate hike would take place in the US before the end of the year.
Another contributing factor to rising yields is the belief that central banks are running out of room on the monetary stimulus front after 7 years of extraordinary measures, including numerous rounds of quantitative easing and forays into negative interest rate policy. In addition, central banks are weighing the benefits of QE against the cost of depressing long dated yields excessively. For example the Bank of Japan demonstrated a desire to steepen the yield curve, raising questions about its willingness to increase quantitative easing further. Speculation has increased that the ECB will taper its bond buying programme. In the meantime, the Federal Reserve has pointed towards a likely interest rate increase and the chance of a second rate cut in the UK has dropped significantly according to Bloomberg consensus data. Bond markets face the prospect of being slowly but surely unhooked from the life-support machine of inexhaustible central bank liquidity.
Yields have also risen due to the increased alertness to fiscal policy playing a more active role going forward in reflating the economy. Expectations that governments will adopt more reflationary policies have increased since the summer. In the US, discussions on the possibility of an easier fiscal policy are linked to the outcome of their Presidential election.
Overall, those factors have combined to lift yields, particularly at the long end. Appian took measures in advance of this decline in bond prices to protect investment income while at the same time providing a diversified portfolio. Appian’s Value Fund and Ethical Value Fund are at the lower end of the range in terms of fixed income exposure and the existing fixed income component maintains a short duration of approximately 4 years leaving it less exposed to price decline during reflationary periods than funds with a longer overall duration. Furthermore, the funds have significant exposure to floating rate notes and inflation linked bonds whose price and coupon payments are linked to interest rate movement and inflation prices respectively.