Fed follow up
02 February, 2016
Bonds and fixed income investments are relatively straightforward. They provide more certainty than other investments — a bond investor can expect repayment of principal at the end of a period, along with a specified income along the way. Where there is uncertainty about repayment (e.g. a risk of default) investors are offered a higher yield, and can choose whether or not to accept the additional risk for the additional compensation. Bond prices will fall when yields rise, and vice versa. And bonds are supposed to behave differently to shares, providing good investment diversification. Straightforward. Well, not always.
There have been some anomalies in the past couple of months (well longer actually) which has made bonds less straightforward than expected. When we last spoke, the US Federal Reserve was about to lift rates for the first time in ten years. This move had long been anticipated, and the market response should have been predictable. However, as we sit here today, US bond yields — short and long-term — are lower than before the December hike, with the market seemingly thumbing its nose at the Fed. Why has this happened? It is likely a combination of volatile share markets, weak oil prices, and weak/disappointing economic reporting in the US and China.
The expected diversification hasn't quite played out as expected either, because many of the high yield securities that investors have keenly bought in recent years happened to be in the oil and gas sector. Like the shares of energy companies, the prices of these fixed income securities were hammered during January and there was something of a flow-on effect to other high yield corporate bonds in other sectors also.
Despite these contrary moves of late though, fixed income investments have provided a calming influence during a period of anxious and disruptive markets. Whether rates are high or low, the Fed is hiking or cutting rates, bonds still provide a much-needed volatility cushion.