Not for the first time in recent history, investors are starting to question their fixed income holdings as the potential for a rise in interest rates in the UK hovers closer.
If interest rate rises are slow and gradual, then their impact on the fixed income asset class is likely to be quite muted. This is because a slow rate increase allows the coupon income to offset and compensate against any capital loss. You also tend to find that as short interest rates rise, longer-term rates stay anchored. This was the experience of the rate hike cycles of the Bank of England through the mid-noughties.
The problem today is that the starting points for coupon income is lower for gilts and corporate bonds than it was then, meaning there is less income cushion to compensate against capital weakness. The second consideration is duration. Generally speaking, portfolios that are concentrated towards government bonds have greater levels of interest rate risk, while those that have more credit risk are less sensitive to rate rises. High yield bonds on the other hand can actually perform well through rising rates, but such instruments behave more like risk assets, so you lose diversification benefits away from investments in assets such as equities.
But what is the real likelihood of a rate rise in the UK in 2017?
Rates were kept on hold in March at 0.25%, though the vote by members of the Monetary Policy Committee was, for the first time since last year, not unanimous, indicating the Bank of England may be closer to raising interest rates than previously perceived.
Despite this, we expect the Bank of England to stay on hold with interest rates this year for several reasons.
While the economy ended 2016 on a strong footing, the outlook for growth is mixed. Current survey data is mostly strong but investment is likely to slow in response to Brexit uncertainty as the year unfolds. The Bank of England has already revised lower its rate of equilibrium employment (from 5% to 4.5%), which means they believe there is more slack in the economy than was previously thought.
While inflation should rise through the first half of the year as the lagged effects of currency depreciation following the Brexit vote take hold, wage growth is still modest and that is a key variable that the central bank is watching.
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