Declining yields for corporate bonds have created the potential for a ‘bond bubble’ under which a rising interest rate scenario could result in significant valuation losses for institutional fixed-income investors, according to a Fitch Ratings study.
The persistence of abnormally low interest rates – and the inevitable reversion to higher levels – is an issue with many dimensions, affecting financial markets, credit conditions, and economic growth. Fitch’s study focuses on identifying, sizing, and contextualizing the risks of rising rates to fixed-income investors.
To provide context to the interest-rate-risk portion of the ‘bond bubble,’ Fitch analyzes the potential losses on a hypothetic yet representative ‘BBB’-rated U.S. corporate bond under a various scenarios. Under one Fitch scenario, a typical investment grade U.S. corporate bond (i.e. ‘BBB,’ 10-year maturity) could lose 15% of its market value if interest rates were to rise to early-2011 levels (a 200 basis point [bp] rise). Under the same scenario, a longer duration bond (e.g. 30 years) could experience a 25% valuation loss.
By comparison, these potential market-related losses would far exceed the roughly 50bps in credit losses on Fitch-rated ‘BBB’ corporate bonds experienced in 2002, the highest historical default rate for this set.
While the $8.6 trillion U.S. corporate bond market could experience significant market value losses, the risks to longer-term, income-oriented investors (e.g. insurance companies) are mitigated by asset-liability management (ALM) and other factors.
Trading-oriented investors and outliers that deviate from sector norms (e.g. longer duration portfolios) face elevated risks in a rising rate environment. Fitch’s analysis looked at the effects across all types of major institutional investor segments.
The timing, pace, and magnitude of future rate increases is critical to how these risks play out. Monetary policy will likely remain accommodative for the next several years, reducing the near-term likelihood of a rate increase. However, a continuation of low rates could exacerbate the ultimate risks to investors, since over time a larger share of portfolios would consist of lower-coupon securities.
