Government bond investors should be very concerned, the current yield levels exhibited by G10 economies are not sustainable, and interest rate sensitivity in global portfolios is at an all-time high as a result of low rates and investors extending duration. The response to lower interest rates by real money investors over the past few years has been to seek higher yields by extending maturities and duration. In an interest rate environment where monetary policy continues to be loose and quantitative easing continues to take out spare supply this has historically worked very well.

However the time has come to consider the unwind of monetary policy and quantitative easing by the Fed, and potentially by the ECB. Given that the average maturity and duration of investors portfolios is now significantly longer than at any time in history the sensitivity to small changes in interest rates is at an all-time high. The mathematics are fairly straightforward if you take a zero coupon bond its duration is the same as its maturity. If interest rates for example move 50 basis points higher in a 10 year instrument then that is .5 x 10 or 5% price loss on that instrument. When we consider that long dated US government bonds only yield 2.5% for a hold period of 30 years that price move is disproportionately large to the benefit one receives for holding that bond.

As you can see in the graph above, we have seen approximately 35 basis points of tightening over the past 12 months in US government 30 year bonds. If for example this tightening were to reverse, and that reversal could be based on expected interest rate rises in the states and potential inflation then just that reversal would cause an investor in 30 year US governments to lose approximately 7%. This is about three times what you are paid to hold this instrument leading us to believe that there is a significant mismatch between risk and reward.

The question therefore is how should investors look at fixed income markets and what instruments should they be buying. The answer is instruments with low interest rate sensitivity, so floating rate instruments make a lot of sense because they pay you a spread over LIBOR if rates go up so that is the yield and instruments that have low interest rate sensitivity because of a credit component also make a lot of sense these include high yield and emerging markets. There has been significant focus on these markets by institutional investors over the past six months as the end of ultra low interest rates are very likely to be around the corner.

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