Time To Consider Bond Alternatives In A Rising Interest Rate Environment

"And bonds are not the place to be these days… Fixed income investors worldwide… face a bleak future"
– Warren Buffett, 2021 Berkshire Hathaway Inc Annual Letter.

Austria is the 14th richest country globally in terms of GDP per capita. Its bonds should be a safe investment, but are they?

The above chart shows that if you had invested in the Austrian 100-year bond issued a year ago, you would have lost 40% if you sold the bond today.

This extreme example illustrates the changing risks of fixed income investments in a rising interest rates environment.

Bond duration risk and convexity

Bond prices are inversely related to interest rates. Bond prices fall when interest rates rise, and the yields of alternative investments become more attractive.

The following chart shows that longer term bonds suffer a sharper drop in value when interest rates rise.

A change in interest rates affects the present value of the future interest payments of a bond exponentially, not linearly. This concept is also known as convexity, which measures the sensitivity of a bond to interest rate changes.

Bonds in the bull market of the last 40 years

Over the past 40 years, US interest rates have fallen from a peak of 14.5% in 1981 to just 0.25%.

If you had invested in US 10-year treasury bonds over this period, your annual risk-free return would be 7.8%[1].

The multi-decade trend has been aided by the deflationary forces of globalization, technology development and slowing population growth.

Bonds have played an important role in a balanced portfolio historically, providing healthy yields and protection during a recession.

Heading into a rising interest rate environment

Interest rates that are near zero have no room to drop further. In 2020, the US Federal Reserve (the “Fed”) indicated that interest rates would remain low as inflation was expected to be transitory. Now, the Fed plans interest rate hikes in 2022 to control inflation.

Besides reducing the value of bonds, rising interest rates increase credit risk as economic activity slows and liquidity tightens.

In his annual letter, Warren Buffett indicated that that fixed-income investments no longer offer yields commensurate with credit risks. Long-term bonds are especially at risk of suffering a significant drawdown when rates rise. The pain for fixed-income investors may have already started.

So where should we invest?

The following chart shows the historical performance of various asset classes[2]

Source: Indices used: Hamilton Lane All Private markets with volatility de-smoothed; Hamilton Lane All Private Equity ex. Credit and Real Assets with volatility de-smoothed; S&P 500 Index; Russell 3000 Index; MSCI World Index; HFRI Composite Index; Hamilton Lane Private Credit with volatility de-smoothed; Credit Suisse High Yield Index; Barclays Aggregate Bond Index; Hamilton Lane Private Real Estate with volatility de-smoothed; Hamilton Lane Private Infrastructure with volatility de-smoothed; FTSE/NAREIT Equity REIT Index; S&P Global Infrastructure Index; MSCI World Energy Sector Index. Geometric means returns in USD. Assumes risk free rate of 2.2% representing the average yield of the ten-year treasury over the last ten years.

Clearly, the absolute and risk-adjusted returns (based on the Sharpe Ratios) of private markets are higher than their public market equivalents. Bonds in a rising interest rate environment are likely to return less than 6% annually with greater volatility.

The closest alternative is private credit. Historically, private credit has provided higher returns and has been more resilient to rising interest rates because it often involves floating rate loans that increase yields as the benchmark interest rates rise.

Meanwhile, private equity is another attractive alternative for investors with a greater risk appetite. The asset class has generated the highest absolute return and highest risk-adjust return over the past 15 years.

Since 2004, we have helped clients build bespoke investment portfolios that capture the opportunities with the best relative value in the environment. We manage US$2 billion worth of assets for over 200 clients. Contact us today to protect and grow your wealth a rising interest rate environment.

Schedule an appointment today.

[1] https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

[2] https://www.hamiltonlane.com/en-US/Basic/78a7dc11-5eae-41e7-9900-2c537d04dbe3/What-Have-the-Markets-Done-Risk-Adjusted-Returns