The apparently robust health of the US economy poses a big risk for investors who hold 10-year US government bonds, warns PM Capital.
PM Capital income securities portfolio manager Jarod Dawson has predicted falls of more than 20 per cent in the face value of 10-year US government bonds.
According to Mr Dawson, many US companies are doing “a lot better than most people think”.
And while a strong US economy is good news for the average American, the inevitable accompanying hikes in US interest rates are bad news for long-duration government bond investors.
“We are seeing firms seriously compete for staff for the first time in a long time and that’s pushing up wages. Unemployment is low and we are also well into the recovery in the US housing market,” Mr Dawson said.
“Additionally, many US companies have been borrowing at 1-3 per cent type levels, sometimes with time horizons as long as 10 to 15 years. They are investing that capital borrowed at record-low levels back into their businesses, often with the objective of earning around 10-20 per cent type returns.”
Mr Dawson said all of these factors feed into growth and inflation over time, which suggests that interest rates should move materially higher over the “medium to long term”.
“Perhaps, of greatest concern for us though is that the way fixed income portfolios are invested now, with many being highly sensitive to increases in actual interest rates, and rates are really still not that far from their at all-time lows,” he said.
“To put it into context, if we consider that a standard US 10-year government bond has an interest rate duration of around nine years, a 1% move in market interest rates effectively creates a 9 per cent move in the capital value of that bond.
“So in a more normalised environment where rates have gone up by say 2-3 per cent, you’re talking about potentially 20-30 per cent type capital losses from an investment like that. That’s a far cry from what many investors would expect from their fixed income portfolios in terms of volatility and potential losses.”
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