How can the negative effect of rising interest rates be cushioned for bonds?

Markets reacted strongly to the interest rate hikes, triggering a downward trend in many asset classes. Our "best-in-class" bond approach with maturity limitation showed a stabilising effect and makes the price recovery already predictable. We thus combine the strengths of diversified investment solutions with the advantages of direct investment: predictability, transparency and cost-efficient risk management.

Interest rates remain dominant topic

The reaction to the Fed's meeting at the beginning of May with the measure of a key interest rate increase of half a percentage point once again illustrated how strongly the financial markets are currently dependent on the outlook for interest rates. Although the interest rate step was in line with market expectations, the following days saw strong movements in all asset classes.

Outlook from the second half of the year

In our view, the central bank's restrictive communication will continue in the second quarter. This means that interest rates will continue to hover around the highs of 2018 (10-year US interest rates at 3.25%). Due to the expected economic slowdown in the second half of the year, we expect interest rate pressure to ease towards 2.5%. Nevertheless, the topic of interest rates will remain present for the coming years with slowly rising levels and the environment for bonds will remain challenging.

Advantages and disadvantages of the individual forms of investment

The current challenging environment is difficult for investors and price losses cannot be avoided. Many investors are invested via different investment instruments such as ETFs, direct investments or funds. We highlight the advantages and disadvantages of the individual investment forms in the current environment and then show our "best-in-class" approach.

ETFs as a "cheap option"

ETFs are favourably managed in relation to other investment vehicles. This is demonstrated by the low annual total expense ratio (TER), which is generally well below that of actively managed funds. However, constant duration ETFs are unprotected against interest rate risk and are fully exposed to market movements, which is not advantageous for investors in the current situation.

Direct investments as an instrument for planning

Direct investments in bonds have many advantages due to their fixed maturity, such as predictability and calculability as well as repayment at maturity, which is usually 100% of the invested capital. However, direct investments can also have disadvantages. These include the large denomination with high minimum investment, lack of liquidity, the costly bid-ask spread when buying/selling and the lack of diversification.
 
For a private investor, a broadly diversified bond portfolio is only possible with a corresponding portfolio size (from approx. 10 million). And even then, important performance drivers are missing, such as access to the primary market with new issues, which is mostly reserved for institutional investors.

Bond funds for diversification

Investments via bond funds generally offer good diversification and the advantage of making investments with smaller amounts. In addition, one gains indirect access to new issues and benefits from active management, which can optimise returns. In the current situation, however, bond funds can also have some disadvantages. High inflows and especially outflows of investor money, especially in times of large price movements, can reinforce price trends and have a negative impact on existing investors. Bond funds are also fundamentally exposed to interest rate risks - comparable to those of a constant duration ETF (see chart).

Some fund managers accordingly use "short strategies" to manage maturities and risks. However, this can also entail additional risks, especially in very tense market phases. The simulation of a short position in government bonds using the example of 2018 shows how this can result in an additional performance loss. The classic bond fund thus becomes unpredictable and can mutate into a non-transparent "hedge fund".

Our "best-in-class" approach in the current market situation

Colin&Cie already addressed the risk of rising interest rates in mid-2018 and took action. When investing in bonds, capital preservation and security are our top priorities. As of 2019, we have therefore abandoned a classic bond strategy and have aligned the investment guidelines of the fund structures we use exclusively even more closely with the needs and goals of our clients by fixing the final maturity.

Via the maturity cap, we thus simulate the desirable characteristics of an individual bond, such as predictability through fixed maturities and redemption at 100% at the end of the term. The fund structure offers the advantages of broad diversification, access to bonds in large denominations and, through professional management, the assurance of a high allocation rate for new issues. In addition, the negative effect of large inflows and outflows can be minimised through the exclusivity of the investment. Since transparency of the investments made is of central importance in addition to the ability to plan, we refrain from short strategies and the use of derivative instruments.

Thus, with our bond portfolio, we offer our clients a solution that moves towards the nominal value at the defined maturity date, regardless of the interest rate environment. This is because by fixing the maturity in our bond strategy, the sensitivity to rising interest rates steadily decreases moving closer to the maturity in 2026. In the current environment of rising interest rates, this means: the negative effect on the bonds is cushioned.

Disclaimer - legal notice

This publication was produced by the Investment Office of the Colin&Cie Group. The information and opinions contained in this document are based on sources we believe to be reliable. However, we cannot guarantee the reliability, completeness or correctness of these sources. All information and quoted rates are only up-to-date at the time of this publication and are subject to change at any time without notice. The content is based on numerous assumptions made by the Colin & Cie Group. It should be noted that different assumptions can lead to materially different results. The forecasts and assessments are only current at the time this publication is prepared and can change at any time without prior notice. Past performance of an investment is not a guarantee of future results. Certain investments can experience sudden and substantial losses in value. This information and views do not constitute a solicitation, offer or recommendation to buy or sell investment instruments or to carry out any other transactions. We recommend interested investors to consult their personal advisor before making decisions on the basis of this document so that personal investment goals, financial situation, individual needs and risk profile as well as further information can be duly taken into account as part of a comprehensive consultation. The information contained in this publication is marketing material that is distributed for advertising purposes only.