Investing in Bonds despite Low Interest Rates?
The US Federal Reserve (Fed) raised its prime rate for the third time in mid-March, by 0.25. Additional interest-rate hikes are expected to follow. What does this mean for bond investors?
Despite a slight rise in the interest rates for fixed-income products, the bond market is still far from normalized. In fact, it is quite the opposite, since interest rates are still low. For instance, the interest rates for 10-year Swiss government bonds are still in the negative range.
As such, the loose central bank monetary policies in place since the 2008 financial crisis are still affecting bond interest rates. This is despite the fact that the US Federal Reserve is working on normalizing its interest-rate policy and has hiked its interest rate three times now since the financial crisis. This normalization is only making slow progress, however.
Bonds Have Lost Value
Current developments are having other negative effects on bond investors in addition to the low interest rates: Since interest rates are rising moderately, the value of the products held in portfolios is falling. This is ultimately resulting in a loss for some investors.
These conditions raise the question of how investors who want to invest in bonds should react. This is because it is not worth investing in the bonds currently issued if interest rates continue to rise. When will we actually reach the turning point in interest rates, though? How long will it last? Or does it perhaps make sense to invest in bonds now after all?
Interest Rates Dependent on Central Bank Decisions
At its July meeting, the ECB maintained its interest rate policy for the time being, although it is expected to drop its easing bias with respect to the asset purchase program (APP) in the near future. A communication regarding the next step will be extremely important.
After the strong move in yields, especially for Italian bonds, ECB President Mario Draghi might be tempted to prepare markets for a very gradual reversal of its loose monetary policy (tapering), which could be formally announced at the meetings in September or October. EUR bond yields are projected to grind higher in the event of gradual normalization.
In contrast, yields in the longer term will be strongly dependent on the ECB's inflation projections and actual economic data. Upward surprises, however, are likely to lead to a sharp increase in yields of APP-eligible assets and vice versa.
Active versus Passive Monitoring of Bonds
Given this situation, many investors are no doubt wishing for a crystal ball. Unfortunately, there is none. However, bonds provide good opportunities, e.g. for diversifying portfolios. Investors need to consider the particular interest rate environment, however, and react accordingly.
The days when investors would buy bonds for the long term and hold onto them until maturity are long gone. When interest rates are low or – in extreme cases – negative, it is hardly worthwhile to try to achieve yields solely from regular interest payments. Instead, active monitoring has become absolutely necessary even for bonds.
Depending on the security, it may make sense to sell a bond early in order to invest in another product with a higher interest rate. However, returns can sometimes also be achieved by selling a bond at the right time, particularly when equity markets are dominated by serious anxiety and investors are retreating to more secure products such as bonds or when expectations that monetary policy will be eased are higher. Increased demand has a positive effect on the value of fixed-income products.
Alternatives to Government Bonds
In addition to active monitoring, it is worth taking a look at alternatives in the bond market. For instance, corporate bonds yield higher interest rates than government bonds, although the difference in interest rates depends on the company's creditworthiness. The less creditworthy a company is, the more interest is paid. Convertible bonds are another option. These are generally converted to shares in the company once they mature. They combine the benefits of equities and bonds in a single product.