Economic Activity Picking Up – Beware of Duration Risk
An interest rate hike by the US Fed and the foreseeable end of the European Central Bank's monetary easing: Swiss investors should gradually be adapting to new market conditions. Credit Suisse offers them support and demonstrates possible replacement and switch opportunities for fixed income holdings.
Fixed income investments are an essential part of every diversified investment portfolio. Under normal circumstances they provide a regular income for the investor because a coupon is paid. However, given the current low or even negative interest rate environment, interest income has fallen considerably. Lengthening the investment horizon or lowering bond quality initially improved performance to some degree – in particular because central banks bought large volumes of bonds. But at the same time, investors became susceptible to duration risk and increased credit risk in the event of a rise in interest rates or more restrictive monetary policy on the part of the central banks.
Shorter Durations Are Advisable
Bonds are not risk free. Duration risk (credit spread and interest rate fluctuation) and credit risk are the two main factors investors need to be aware of. If a bond has a long duration, this means that its maturity is in the distant future. The longer the duration, the further a bond price falls if interest rates rise. Therefore, in the current environment of interest rates gradually being normalized, investors should concentrate on reducing durations.
Investors Should Position Themselves at the Right Time
The US Fed already increased interest rates for the first time in March. Given our view that the ECB will begin communicating a reduction in quantitative easing later this year, we believe it is important that Swiss investors start considering how to position themselves ahead of an ECB tapering. Reducing duration risk is crucial for them.
Financials Still Positive
Within the fixed income asset class, we prefer investment grade shorter duration and emerging market bonds because their yields are picking up. We are also focusing on convertible bonds because of their built-in equity optionality. Within sectors, we remain positive on financials – the financial sector is the only one whose yields were not distorted by the central banks' quantitative easing programs.
LIBOR-Based Mortgages as an Alternative
An alternative way to reduce duration for Swiss investors could be through exposure to short-term LIBOR-based mortgage risk. LIBOR-based mortgages in the Swiss market are currently subject to an embedded LIBOR floor at zero. As a result, as soon as the LIBOR rate rises above zero, the interest fixing of the LIBOR mortgage will follow at the next interest payment date. Future interest income will therefore increase. "In exchange, investors bear the credit risk associated with the underlying mortgages and property values in case of borrower defaults," says Jessie Gisiger of Fixed Income Strategy. "Still, with our expectations of a gradual reduction in monetary policy accommodation, we do not expect default risks to increase significantly as a consequence."