With interest rates rising globally, fixed-income returns have been mostly negative year to date. But are European bond investors doomed to suffer continuing losses? Not necessarily. There are several ways to combat rising rates.

Pressure on Bond Returns

It’s been a rough start to the year for bond investors. Since the beginning of 2018, US Treasuries have returned about –1.2%* and leading aggregate bond benchmarks have declined too. With inflationary expectations stirring and more US rate rises in the pipeline, more pain for bondholders is in prospect.

Similarly, in Europe the European Central Bank (ECB) is expected to continue to taper and is likely to stop its asset purchase program later this year, so euro fixed-income markets may be under pressure too. We believe that rates could rise higher than the market expects, particularly in Europe. Now could be a good time to reorientate your fixed-income portfolio and adopt more flexible strategies.

Here’s how:

1) Don’t be limited by an aggregate approach

Despite the recent sell-off in fixed income, yields in Europe are still near record lows. Traditional aggregate-type bond portfolios provide little protection against rising rates. In Europe specifically, we believe strategies that passively follow benchmarks such as the euro aggregate are vulnerable. With a duration of almost seven years, a 10 basis point (b.p.) rise in rates would trigger a price fall of almost 0.7% (7 x –0.1%), wiping out a whole year’s yield. In addition, should yields rise by 50 b.p., it would take 38 months for the euro aggregate benchmark to recover the losses.

A move to strategies with lower (although not zero or negative) interest-rate risk and selectively higher credit risk will provide higher yield and better protection, in our view, particularly in Europe. For instance, subordinated financials bonds (i.e., Additional Tier 1), European high yield (HY) or US mortgage-backed securities (MBS) should cope much better with rising rates. That’s because higher-yielding bonds are typically less sensitive to moves in interest rates (but more sensitive to changes in credit spreads).

2) De-emphasize rates and focus selectively on credit

European investors should be mindful of the risk of rising rates in Europe. So far the market has responded calmly to expectations of ECB tapering, probably helped by extremely dovish ECB communications. However, the more successful the ECB is in suppressing market expectations today, the more severe the market reaction could be when the extent of the shift in ECB monetary policy becomes clear, putting more pressure on yields. On the other hand, as economic growth in the euro area gains momentum and European corporates reduce their debt burdens, the environment should improve for European corporate bonds.

The euro HY market in particular has good technical support. Net supply is expected to remain subdued and lower than in previous years, while demand should stay strong. Despite outflows from HY mutual funds (€5.1 bil. in 1Q**), investment-grade credit portfolios continue to invest tactically in HY bonds, as euro investment-grade corporate spreads remain tight and will likely continue to be supported by the ECB.

Importantly, investors should stay active to keep defaults low. Even in an improving economy, there will still be company-specific problems that trigger defaults on credit bonds. Our experience indicates that skillful active management can identify the most at-risk issuers. As a result, a well-managed active portfolio should experience fewer defaults than the benchmark.

3) Go off-benchmark for hidden opportunities

Aggregate bond benchmarks do not capture the full range of opportunities available to investors today. For example, the financial sector includes a relatively new category of subordinated bonds—the Additional Tier 1 (AT1)—which are not included in any benchmark. Even after the strong rally those securities experienced last year, we still find value in AT1.

Yields remain attractive while banks’ balance sheets have continued to improve in terms of increased capital and reduced nonperforming loans. In addition, banks’ profitability would likely benefit from higher yields and a steeper yield curve, as this would improve their profit margins. Of course, there are risks. Investors in AT1 can be converted into equity or written off to zero, and the coupon can be switched off with an accompanying deterioration of capital. However, we believe those risks remain relatively low given the improvements in the banking sector.

Finding the Right Mix

Each of these three approaches can help combat rising rates in different ways. By recognizing the risk—and acting now—investors can prepare their allocations with the right mix of strategies for a more challenging interest-rate environment.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.


*As at March 31 2018 in US Dollar terms

**Source: J.P. Morgan. This figure is equivalent to 7% of the combined assets under management in the J.P. Morgan fund universe.

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