Much has been said over the summer months about if and when the US Federal Reserve will ‘taper’ $85bn worth of monthly bond purchases. Some argue that it is only a matter of time; others do not appear too convinced that it will happen before year end whilst a recent Bloomberg survey shows that 65% of the 48 economists who took the survey believe that official tapering will be announced in the forthcoming Federal Open Market Committee (“FOMC”) meeting in mid-September.

What is for certain is that the debate has caused a stir in financial markets and has got market analysts re-thinking their strategies and portfolio managers re-positioning their portfolios in the wake of a major change in interest rate expectations.

But what is this Fed tapering really about? The term “tapering” began to form part of everyday jargon in the financial markets from May 22 of this year, when US Federal Reserve Chairman Ben Bernanke stated before Congress that the Fed may taper (or lessen or diminish) the bond-buying program (better known as quantitative easing (QE) in the coming months. This announcement brought with it a bout of heightened volatility across all asset classes causing a stir in the bond markets. US Treasuries sold off for the better part of June and July whilst benchmark high grade European government bonds and the corporate bond market also had their fair share of a market correction.

Ever since the financial crisis broke out, the world’s largest central banks adopted a number of measures and strategies aimed at safeguarding their domestic economies which were on the brink of financial meltdown. In the US, the Federal Reserve embarked on a number of QE programmes, with the most recent one being the $85billion worth of monthly bond purchases, which effectively means that the Fed is expanding its balance sheet by pumping $85bn worth into the economy.

QE was never really intended to last forever. In fact, in previous testimonies, Bernanke had made it clear that the continuation of the program was dependant on incoming economic numbers, namely GDP, unemployment and inflationary data. Bernanke stated on 22 May 2013; “If we see continued improvement and we have confidence that that's going to be sustained then we could in the next few meetings … take a step down in our pace of purchases.” This was just one of many statements made by Bernanke that day. However, it was the one that received the most attention by the markets because it came at a time when investors were already concerned about the potential market impact of a reduction in a policy that has been so kind to both equity and bond markets. Having said that, it is apparent from the minutes of the June FOMC meeting revealed that support for QE and Fed tapering is by no means unanimous.

To a lesser extent, the Federal Reserve is closely looking at economic data coming out of Europe and China, which numbers give FOMC members a good gauge on the state of the global economy and the pace of economic growth which could infiltrate the US economy. As opposed to the US, yields in the Eurozone appear to be somewhat capped by growth which remains structurally fragile. The ECB continues to be dovish providing lower-for-longer guidance whilst short-term political uncertainty persists, such as the forthcoming elections in Germany and political instability in Italy and Portugal.

Whilst Bernanke’s tapering statement did not represent an immediate and obvious shift from one asset class to another, it nonetheless startled the markets. In the recovery that has followed the 2008 financial crisis, both equity and bond markets have produced remarkable returns despite lacklustre economic growth. The general consensus is that the Fed policy (and other leading central banks too) is the reason for this disconnect. Once the Fed begins to withdraw liquidity from the market, we might well begin to see markets perform more in line with economic fundamentals, a scenario which bodes well for equity markets and not so much for bond markets.

In fact, in the wake of the Fed’s announcement, bonds sold off sharply, while equity markets began to exhibit higher volatility than they had previously. Market participants need to appreciate that tapering is not an immediate, dramatic event. Instead, it is likely to take place over an extended period of time so as to create minimal market disruption. The fact is that tapering does not represent a sudden end to QE, nor is it likely to be a steady, predictable decline. Instead, it is expected to be a bumpy process that takes place over a period of a year or more.

That leaves us with having to digest all the information thrown at us, from FOMC meetings and their respective minutes, ECB meetings, global economic data, market movements (such as interest rate movement and movement/shifts) as well as credit spreads between the high grade bonds and high yields bonds. It is this concoction of information which forms the basis of setting market direction, interest rate expectations and portfolio positioning.

It then comes as no surprise if the large part of investors notice that the valuations of their bond portfolios have been, to the say the least, volatile since mid-May. With nominal GDP growth in the US on the rise, personal consumption showing signs of reprieve and unemployment slowly improving, the likelihood of tapering commencing sooner rather than later seems to have increased.

In view of these developments, it is of paramount importance for investors to position themselves adequately and cushion their bond portfolios for any expected volatility and possible re-pricing. In a scenario where interest rates are expected to increase, the long end of the yield curve is not where you would normally want to be, as long dated bonds are most susceptible to a market correction. Although the entry points could be deemed to be attractive, the potential de-valuations in longer dated bonds could more than offset the yield potential on the investment, rendering the risk-reward trade-off insufficient in the long term. In anticipation of steepening benchmark yield curves (since yields at the longer end of curve increase at a faster rate than yields at the shorter end of the curve) shorter dated bonds will not only offer a superior risk-reward trade off but will also provide the investor the opportunity to plough back maturing proceeds in the bond market at more attractive yield levels.

Default rates remain anchored at low levels (robust corporate earnings and contained corporate leverage levels should help prevent further downgrades) and are expected to remain so as global economic activity picks up. This renders the process of stock selection crucial as we feel that from this point forward, exposure to market risk is unavoidable. It is choosing those bonds which are less volatile than the market (in a rising interest rate scenario) which will prove to be the winning formula. Having a bond portfolio laden with winners is close to impossible, but keeping a well-diversified portfolio of good credits will ensure investors are rewarded commensurately. Selectively, High Yield bonds offer a decent buffer against higher rates. Despite its risk profile, the High Yield market is likely to outperform high-grade bonds over the next 6-12 months but could well come under pressure in the longer run.

Going forward, we keep a close eye on the forthcoming ECB meeting on 05 September 2013 and more importantly 18 September to take cue on where the markets are heading. What is certain is that the market seems to have priced in an imminent announcement of tapering in the FOMC’s 18 September 2013 meeting (a reduction from $85billion to $70-$75billion in monthly bond purchases seems to be on the cards); anything surprising to either the upside or downside could see volatility in bond markets emerge once again.

Calamatta Cuschieri & Co Ltd, Company registration number C13729 (‘CC’) is licensed to conduct investment services in Malta by the Malta Financial Services Authority. This article is prepared for information purposes only and does not constitute investment advice or marketing communication. It does not constitute an offer or invitation to any person to buy or sell any investment or to enter into any business relationship with CC. This article is based on information obtained from reliable sources but which have not been independently verified. CC is under no obligation to update the information in this article. No person should act upon any recommendation in this document without first obtaining professional investment advice. CC does not accept liability for any actions, proceedings, costs, demands, expenses, loss or damage arising from the use of all or part of this article.

The information in this article is valid as at August 28, 2013.