What do fixed income investors do in a rising interest rate environment? Part 2

The Sterling Report

With Marian Ross

Saturday, August 23, 2014

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Global economic update

Within the last 12 months, the FOMC announced its decision to taper its monthly US$85 billion asset purchase programme, by US$10 billion at each of its last five meetings. The Fed currently purchases US$35 billion of securities each month. The FOMC also committed to maintaining the Federal Funds Rate between zero per cent and 0.25 per cent. Despite second quarter economic growth of four per cent and unemployment of 6.1 per cent, the US economy still shows signs of weakness. Retail sales remained stagnant month on month and initial jobless claims came out above expectations.

Most recently, the European Central Bank maintained negative deposit rates for Banks that leave funds on deposit overnight. The Euro area economy grew by just 0.1 per cent in the second quarter of the year. The region's largest economies produced particularly disappointing results. German and Italian economies contracted while the French economy remained stagnant quarter on quarter. The ECB is attempting to stave off deflation and stimulate the EU economy with negative interest rates but is contemplating a programme of quantitative easing in 2015 as a last resort.

Despite improved UK economic data, the Bank of England (BOE) has also reiterated its commitment to a low interest rate regime in light of a decline in wage growth and heightened geo- political risks.

Interest rate outlook and search for yield

We do anticipate a gradual rise in interest rates in the next eight to 24 months coupled with the staged elimination of the Federal Reserve's asset purchase programme. However, in light of the absence of wage inflation in the USA, weak consumer spending, and the evolving threat of geopolitical risks, we do expect the overall monetary policy stance of the US Federal Reserve and BOE to remain largely accommodative for at least the next 12 months.

Still, investors must protect themselves from the potential price risks that are inherent in a rising interest rate environment. Investors should buy for yield and minimise the duration of the instruments they purchase. This may require investors to accept a more modest return than they were previously accustomed to.

However, we urge investors to be wary of obscure companies and issuers in emerging markets. The yields on the vast majority of these instruments are not high enough to compensate investors for the high risks inherent in the security. The low interest rates of the developed markets have induced investors to look for yield elsewhere. This has fuelled a tremendous rally in the price of emerging market debt and equity. As interest rates rise and the developed economies recover, the emerging markets will become less attractive to investors and the prices of these securities will undoubtedly decline. Speak to your investment advisor about less risky shorter duration bonds; this should calm your anxiety about rising interest rates.

Marian Ross is Assistant Vice President - Business Development at Sterling Asset Management. Contact us at: info@sterlingasset.net.jm. You may visit us on Facebook or follow us on Twitter and for more information please visit our website www.sterling.com.jm




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