The raft of recent central bank meetings in late October and early November offered clarity but few surprises on the future direction of monetary policy – the Bank of England lifted interest rates from their decade-long slump to 0.5%, while the US Federal Reserve set the stage for a further rate hike in December 2017. More broadly, rhetoric from key policymakers firmly suggests that interest rates will continue to rise and monetary stimulus will gradually be withdrawn over the coming months.
Investors concerned about what this could mean for their bond portfolios are spoilt for choice when it comes to looking for clues in economic and financial indicators.
But understanding the credit market breakeven, and the potential benefits of short duration bonds, will be crucial to mitigating risk.
More risk for less yield
The post-crisis backdrop of ultra-loose monetary policy has been kind to investors in general, but those with their money in fixed income are particularly vulnerable to interest rate hikes. This is because the duration of the global bond market has gradually risen, yields have steadily declined.
The relationship between yield and duration is key to understanding the credit market breakeven, and its impact on bond portfolios. We can see that the credit market breakeven (or Sherman ratio, calculated by dividing yield by duration) has steadily declined since 2007
Not to be confused with the inflation breakeven, which describes the difference in yield available on nominal and inflation-linked bonds of the same maturity, the credit market breakeven indicates the market’s sensitivity to a shock in interest rates. A lower value reflects a greater sensitivity to change.
What this breakeven represents in practical terms is the extent to which interest rates would have to rise in order to wipe out the positive total return of the global credit market – in others words, how far would interest rates have to increase before falling bond prices overwhelm the available yield, resulting in a capital loss?
Sensitivity to interest rates has more than doubled in 10 years
The breakeven point of the all-maturities global credit universe has fallen from 97 basis points (bps) to 39bps over the last 10 years. This means the combination of lower yields and higher duration has more than doubled the interest rate sensitivity of the overall market, leaving investors more exposed to rate rises. With interest rates at major central banks on course to tick higher, managing duration will only become more important.