Volatility & Interest Rate Sensitivity

A recent feature of global markets has been increased volatility in both equities and bonds. Clearly the Greek debt crisis has weighed on equity markets especially in Europe. Incidentally UK banks have very little exposure to Greek debt although the knock on effect of a default could be significant given the EU is our biggest trading partner and the potential for contagion. The negotiations in the next few days, the proposed Greek referendum and the markets’ response once the 30 June deadline is reached will prove interesting.

Elsewhere China’s Shanghai Composite Index fell 8% on Friday. The index is now a whopping 20% below its peak, reached just a few weeks ago. Fears about monetary policy easing were a factor but Chinese equities have risen strongly in the last year and I suspect that investors have been taking profits.

In the bond market there has been a huge spike in volatility. You may recall in my last blog at the end of June I reported a sell-off in government bonds. According to Bloomberg yield volatility on 10 year German government bunds has risen to nine times the 15 year average.

So what do I conclude? This increase in volatility could be the early signs of trouble ahead. Markets are clearly uncertain and nervous and could be tipped into a full blown crash. That trigger could be the start of rising interest rates, expected in the US later this year and to be followed shortly afterwards by the Bank of England. As you may be aware the prices of fixed interest securities which include government and corporate bonds tend to fall when interest rates rise because the relative value of future coupons is eroded. Long dated investment grade bonds are particularly sensitive to changing interest rates whilst short dated issues and high yield bonds are less affected. This nicely brings us on to an interesting feature of the bond market called “duration.” Duration is a measure of the interest rate sensitivity of  bonds. Bond fund managers can actively manage duration to reduce risk for investors. This will be a subject for a future post.

To wrap up I want to briefly cover action investors can take to mitigate risk in their portfolios. There is a case for doing nothing other than parking the portfolio. This is the classic buy and hold strategy appropriate for long term investors especially those who are not overly risk averse. The thinking is that markets may well crash but they will recover and such investors are happy to ride the short term volatility. Whilst I advocate long term investing I prefer employing active tactical overlays to complement this strategy. So in recent months I have been advising clients during annual investment reviews to undertake selected profit-taking, either to cash or to undervalued markets or sectors. I have also advised switching from bond funds with high durations, for example gilt funds to those with lower interest rate sensitivity.

Interesting times are ahead. It is never dull being an investment adviser.

This blog is intended as general investment commentary and principally reflects my own views.  You should seek individual advice before making investment decisions.