Declining yields for corporate bonds have created the potential for a ‘bond bubble’ under which a rising interest rate scenario could result in significant valuation losses for fixed-income investors.
The persistence of abnormally low interest rates – and the inevitable reversion to higher levels – is an issue with many dimensions, affecting financial markets, credit conditions, and economic growth.
To provide context to the interest-rate-risk portion of the ‘bond bubble,’ Fitch has analysed the potential losses on a hypothetical yet representative ‘BBB’-rated US corporate bond under various scenarios.
Under one scenario, a typical investment grade US corporate bond - ‘BBB,’ 10-year maturity – could lose 15 per cent of its market value if interest rates were to rise to early-2011 levels (a 200 basis point rise).
Under the same scenario, a longer duration bond, such as 30 years, could experience a 25 per cent valuation loss.
By comparison, these potential market-related losses would far exceed the roughly 50 basis points in credit losses on Fitch-rated ‘BBB’ corporate bonds experienced in 2002, the highest historical default rate for this set.
While the $8.6trn (£5.4trn) US corporate bond market could experience significant market value losses, the risks to longer-term, income-oriented investors are mitigated by asset-liability management and other factors.
Trade-oriented investors and outliers that deviate from sector norms, such as longer duration portfolios, face elevated risks in a rising rate environment. The Fitch analysis looked at the effects across all types of the major institutional investor segments.
The timing, pace, and magnitude of future rate increases is critical as to how these risks play out. Monetary policy is likely to remain accommodative for the next few years, reducing the near-term likelihood of a rate increase.
However, a continuation of low rates could exacerbate the ultimate risks to investors, since over time a larger share of portfolios would consist of lower-coupon securities where value is particularly sensitive to rising yields.
In a lower-probability but more volatile scenario, rates could increase because of unexpected changes in investor behavior, such as a drop in appetite for low-yielding bonds, structural reductions in foreign official purchases of Treasury securities, or a sharp increase in inflationary expectations.
Robert Grossman is managing director at Fitch
