Investors have to be prepared for the impact of rising interest rates on their portfolios, investment firm BIAS warned in its latest quarterly market briefing.
2012-13 has seen a drop in bond prices, indicating higher yields in bonds. Particularly longer-dated Treasury bonds fell in value during the first quarter.
“Investors need to be prepared for the effect of rising yields on bond prices,” says BIAS CEO Robert Pires.
Although the head of the Federal Reserve Ben Bernanke confirmed in May that he has no intention of discontinuing an $85 billion a month quantitative easing programme in the near future, a period of higher yields and interest rate will have to come at some point. When the Federal Reserve abandons its quantitative easing practices the pressure on interest rates will impact bond prices.
As yields rise, the prices for bonds fall; and the prices of longer maturity bonds fall more steeply than those of shorter-dated bonds.
“For this reason we have kept our clients in short-dated bonds, even though the returns on them are fairly marginal,” Pires says.
Yet premium bonds, with coupons higher than prevailing interest rates in the market, still have a use in a portfolio, he adds. Premium bond prices fall as they approach maturity, but investors are typically prepared to take that depreciation because of the excess yield they are getting over current market rates.
“We don’t want you to be put off by them. You need to know that they are going to drift down and be a drag on the performance of the portfolio in the years to come.”
This can be a particular problem for clients, such as retirees, who are dependent on income from their portfolios. BIAS addresses this drag on client portfolios by shifting clients to higher quality equities that pay dividend income, such as the S&P Dividend Aristocrats.
The risk-return profile of fixed income and equity securities shows that fixed income securities provide less risk to a portfolio, but over the past ten years certain categories, particularly the S&P 500 categories and the S&P Dividend Aristocrats, have provided higher rates of return.
“What has happened in recent years as the quantitative easing of the Federal Reserve has lowered the level of interest rates artificially, fixed income managers have pushed out their clients’ risk tolerance by putting them into lower credit quality otherwise known as higher yielding bonds,” Pires states.
“They have to yield more because they are lower credit quality. Here is the problem: higher yield bonds do default on interest payments from time to time, leaving investors with cents on the dollar from what they have invested.”
The preference of BIAS is to put client funds instead into the ownership of higher quality equities, demonstrated by the ability to consistently raise dividend payments over a 25 year period, as in the case of the S&P Dividend Aristocrats. The advantage for the portfolio is the expected dividend income in addition to the potential for capital appreciation.
The general trend of investors moving from bonds into stocks in search of better returns was reflected in the equity markets, in particular the MSCI World Index, which rose considerably in the last quarter of 2012 and the first quarter of 2013.
Japanese stock markets also fared well following a change in monetary policy and a depreciation of the yen against the dollar.
The question is whether a correction in equities is on the way?
While there is still appetite for equity risk and the relative strength indicator, a technical momentum indicator which compares recent gains to recent losses, shows no sign of equities being overbought yet, BIAS says four of the six market weakness indicators it uses point to a correction in the market.
These include the Russell 3000 index underperforming the Russell 1000 index, the S&P Mid-Cap underperforming the S&P Large-Cap index and that valuations are at or above the median of 15 times earnings.
Moreover, defensive stocks like staples are starting to outperform cyclical stocks which benefit most from an economic recovery, indicating a market correction.
However, BIAS points to the last four major equity market corrections since 2010 which have been gradually smaller in magnitude and estimates any market downturn would reach a maximum of 5 per cent.
Commodities meanwhile have been weak with the major commodity indices down in the last six months. Gold is moving into bear territory after 127 months of bull market, oil prices are in equilibrium and base metals, such as copper are in good supply with no external shocks to suspect, BIAS said.