May 29, 2017    5 minute read

The Importance Of Hedging Against Bond Risk

Staying Safe    May 29, 2017    5 minute read

The Importance Of Hedging Against Bond Risk

Investors around the world are uncertain. Terrorist attacks, economic downturns and unsustainable budget deficits have prompted a flock to bonds in recent years and particularly T-Bills and German bunds. The upsurge in corporate earnings across the USA has led to growth in demand for US corporate bonds as well as investors search for high yields in a low-interest-rate world.

Bond Risks

The most commonly cited risks to holding bonds are default and inflation; the higher the default probability, the greater the risk premium (also known as default spread) on the bond and subsequently the higher the promised payment. Government bonds, particularly T-Bills are often used as a diversification or hedging tool for asset portfolios, due to their low (but non-zero) risk of default.

The risk of inflation in advanced economies has led to an increase in scepticism about the real returns on holding bonds being around 0 or even negative. Therefore, investors have increasingly decided to use US Treasury Inflation-Protected Securities as the new way of diversifying predominantly equity portfolios.

These work by paying interest on the inflation-adjusted face value of the bond each year. For instance, a 2% bond has a face value of $1000 in the first year pays $20, but following 4% inflation in the second year, the face value is adjusted to $1040, and $20.8 is the new payment. This, therefore, protects the investor from a fall in real returns.

Central banks’ loose monetary policies have also contributed significantly to bond market risk, which has negatively impacted pension funds. With the proportion of elderly people drawing pensions rising each year, the low interest rates have resulted in a cash shortfall, whereby pension funds need to invest more money in bonds to meet the growing pension liabilities.

Quantitative easing has resulted in a fall in bond yields and rises in bond prices, which have exacerbated pension fund deficits, which grew to £710bn after the QE announcement in August 2016 versus £470bn in January 2016.

A more general risk to bond investors is the prospect of a rise in interest rates in the USA, UK and Eurozone as well as emerging markets. A rise in the base rate channels through to lower bond prices due to depressed demand for existing bonds and large selling volumes, given that newly issued ones will pay higher coupons.

For example, holders of a 10-year bond issued last year will see a decline in its price following a rise in interest rates, since 10-year bonds issued from now on will deliver a greater rate of return. The current speculation is that the Federal Reserve will hike interest rates in June 2017 and continue to raise rates steadily over the next two years. This emphasises the need to not over-rely on 10 to 20-year bonds as a hedging instrument because the fall in prices can cause a decline in portfolio values and lower realised returns.

Hedging

This analysis gives rise to a new requirement: the need to hedge the interest rate risk on bonds. Over the counter interest rate swaps have become an increasingly common mode of hedging prevalent global interest rate risks for corporations.

For instance, a company like Federal Express is cyclical. In a downturn, floating rate bond liabilities can be swapped for fixed interest rate payments through a broker, as this will allow them to benefit when interest rates rise. The counterparty (agreeing to floating rate) now pays the difference between the fixed rate agreed and the new higher interest rate to Federal Express. In the recovery stage of the US economy, ‘cyclical’ companies witness a rise in revenues, thus enabling them to reduce bond interest expenses without the swap.

On the other hand, the other main type of risk, call risk, is inversely related to the interest rate environment, which gives bond investors a sigh of relief after a decade of low interest rates around 0%. Callable bonds issued by companies can be repaid early once the market price reaches the call price of the bond and these are called with the intention to issue new bonds at a lower interest rate.

Not Quite Risk-Free

The risk to bondholders arises from the fact that they may not be able to find a similarly high-yielding alternative to reinvest funds received from the early repayment. This was prevalent over the last 10 years, with the threat of negative interest rates leading to further uncertainty in what was regarded to be the safest financial market for returns.

Although corporate bonds almost always pay a higher interest than gilts due to the default spread added, the threat that the interest rates could carry on falling even below 0 was enough to exacerbate call risk and the need to find an alternative ‘safe’ investment for an investment portfolio.

Bonds are therefore not risk-free as is often perceived by investors and financial commentators. Though the ‘fixed income’ aspect certainly improves their risk rating relative to stocks (which can have adjustable dividends) or options (where you can lose all capital staked as an individual investor), investors must understand these macroeconomic risks and find ways to hedge their exposure in these uncertain times.

 

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