Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Global Bond Markets And Strategies For Rising Interest Rates

Global Bond Markets

The past 3 decades have seen a strong bull market for US fixed income investors, a trend traced back to 1981 when Fed Chairman Volker raised the Fed Funds rate to a record 20% to fight off double-digit inflation. The Fed made it clear in the May FOMC meeting that quantitative easing will continue until unemployment lowers to 6.5% or projected inflation reaches 2.5%. Despite this, most economists in a recent Bloomberg survey believe US treasury yields will rise over the next 18 months, with median forecasts for 10-year yields at 2.20% by the end of 2013.

The Eurozone continues to struggle with austerity measures and its inability to service its massive debt. The ECB recently cut its benchmark rate to a record low of 0.5% to help its battered economies, a move largely seen as ineffective by markets. Investors expect ECB President Draghi to use more aggressive tools such as quantitative easing in order to stimulate real growth, instead of merely continuing the "extend and pretend" game. As such, the Eurozone continues to be mired in recession until more drastic measures are taken by monetary authorities. 10-year yields for France, Germany, Italy, Spain, and Portugal remain largely unchanged at 1.837%, 1.268%, 3.877%, 4.165%, and 5.366%, respectively. Yields are expected to be anchored in the near future, although high yield bonds continue to be an attractive source of return.

Prime Minister Shinzo Abe has been pursuing an aggressive monetary policy to fight deflation and lift Japan out of a two-decade long recession. The BOJ plans to double Japan's monetary base over the next two years in an attempt to reach an inflation target of 2%. Yields continue to remain suppressed, with the 10-year at 0.590%. With little room for price appreciation and low yields expected to persist for some time, investors have reallocated to other fixed income markets in search of higher yields.

Chinese capital markets are opening up and creating new opportunities for investors, although the RMB remains restricted by the government. The onshore bond market, traditionally dominated by government securities, has recently seen significant issuances of domestic corporate bonds. The less restricted offshore bond market has grown larger than $185 bil and is rapidly becoming a major driving force in the Asian bond market. With the RMB poised to become the world's third largest reserve currency within 10 years, it's clear that China is becoming a significant factor in global bond markets.

Strategies for Rising Interest Rates

Several strategies can be used to mitigate interest rate risk in an environment of rising rates. One method is a sector allocation tradeoff, in which duration is replaced with credit risk (ex: allocating from Barclays Aggregate Index to US Corporates). Credit spreads are negatively correlated with interest rates, and spreads will narrow as rates rise. This strategy works best in a consistent bull market, as credit risk is highly correlated with equity performance during a selloff.

Another strategy is to maintain overall exposure targets while shifting allocations to shorter duration securities. This involves replacing longer maturity securities with shorter ones in a specific ratio determined by relative durations. An understanding of how a higher interest rate environment might evolve is especially important, as switching to shorter duration too early will cause underperformance from missing out on additional yield.

A third strategy involves combining existing duration with an interest rate hedge overlay. The hedge can be achieved by shorting portfolio duration using US treasuries or treasury futures. While this offers a symmetric payoff, the negative carry can be quite costly. An alternative to this would be a payer swaption (pay fixed, receive floating) that pays off if interest rates rise sufficiently. Similar to insurance, a swaption strategy would offer an asymmetric payoff.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.