Why bond investors need to know the breakeven

Ahead of the upcoming raft of central bank meetings in late October and early November, rhetoric from key policymakers firmly suggests that interest rates will rise and monetary stimulus will gradually be withdrawn over the coming months.

Investors concerned about what this could mean for their bond portfolios are spoilt for choice when it comes to looking for clues in  economic and financial indicators.

But understanding the credit market breakeven, and the potential benefits of short duration bonds, will be crucial to mitigating risk.

More risk for less yield

The post-crisis backdrop of ultra-loose monetary policy has been kind to investors in general, but those with their money in fixed income are particularly vulnerable to interest rate hikes. This is because the duration of the global bond market has gradually risen, yields have steadily declined.

The relationship between yield and duration is key to understanding the credit market breakeven, and its impact on bond portfolios. We can see that the credit market breakeven (or Sherman ratio, calculated by dividing yield by duration) has steadily declined since 2007:

Not to be confused with the inflation breakeven, which describes the difference in yield available on nominal and inflation-linked bonds of the same maturity, the credit market breakeven indicates the market’s sensitivity to a shock in interest rates. A lower value reflects a greater sensitivity to change.

What this breakeven represents in practical terms is the extent to which interest rates would have to rise in order to wipe out the positive total return of the global credit market – in others words, how far would interest rates have to increase before falling bond prices overwhelm the available yield, resulting in a capital loss?

Sensitivity to interest rates has more than doubled in 10 years

The breakeven point of the all-maturities global credit universe has fallen from 97 basis points (bps) to 39bps over the last 10 years. This means the combination of lower yields and higher duration has more than doubled the interest rate sensitivity of the overall market, leaving investors more exposed to rate rises. With interest rates at major central banks on course to tick higher, managing duration will only become more important.

Short duration and rising yields

Shortening duration is one of the key ways in which investors can attempt to mitigate the impact of rising yields. As shorter-dated bonds naturally mature earlier than their longer-dated peers, they allow you to reinvest sooner and take advantage of higher yields available in the market place.

The chart below shows the relative impact of a 50bps, 75bps and 100bps increase in government bond yields on total returns in the global credit market. We can see that the all-maturities market suffers significant drawdowns for even a marginal increase in yields, while the short duration portion of the market – bonds with maturities of five years or less – is more resilient to periods of rising yields. 

Why now?

Structural changes in the yield curve have also lowered the cost of going short duration, as Nicolas Trindade, senior portfolio manager at AXA Investment Managers explains: “Flattening in both the yield and credit curves over the last five years has effectively provided an attractive entry point for short duration, particularly in the sterling credit market.”