Even though inflation is decreasing, within the Eurozone, long-term government bond yields have reached new highs in over a decade. On October 4th, the 10-year BTP reached a yield of 5%, for the first time since 2012. However, this time it is not a local crisis of confidence in Italy: even the super-secure German bund exceeded a 3% yield on the same day, reaching a record high since May 2011. Analysts assert that if European bond yields are rising, the cause can be found in the United States, where the persistent strength of the labor market, as evidenced by recent data, has pushed expectations for inflation and the yields of US Treasury Bonds.
BTPs, a Safe Haven With Reserves
Investing in government bonds is commonly considered a safe haven for small investors who are not inclined toward the risk of stocks. The Italian Treasury, on its part, has sought on multiple occasions to attract this type of risk-averse investor with special issuances such as the inflation-indexed BTP Italia, the BTP Futura, and the BTP Valore. The reason for this perceived trust is that typically, the small investor holds the government bonds until maturity, collecting the coupons and obtaining the full refund of the invested capital. Consequently, what happens to the price of the bond in the years between purchase and refund seems to be fluctuations that concern little to those who invest following this approach.
However, when investing in the long term, unexpected events can occur: a sum invested in a BTP that has many years until maturity may need to be liquidated ahead of time. At that point, one would have to sell the bond under the conditions offered by the market. Sometimes this occurs at a profit, but in the current phase of high rates, it is much more likely that those who were to sell a BTP bought a few years ago would receive an amount less than the initially invested capital.
The reason is not difficult to understand. Today, a five-year bond like the BTP Valore is offered to the market (in the issuance from October 2nd to 6th) with an average annual yield of 4.36%; three years ago, in the midst of the COVID era, an Italian bond with a five-year life yielded around 2.3% annually. Someone who now held a bond that pays such low coupons could only resell it at a discount on the price, in order to compensate for the difference in yield from the new comparable issuances. This is the well-known inverse relationship between bond yields and prices.
An example of the potential damage caused by rising rates is represented by the BTP Futura, maturing in April 2037, the bond reserved for families that the Ministry of Economy had issued in April 2021: assuming it was purchased for 1,000 euros at issuance, today, net of the collected coupons, one would only take home 634 euros. Justifying a hefty 36.6% loss is precisely the difference between the coupons offered by that BTP and those currently offered for new comparable bonds.
Managing Rate Risk by Controlling the Duration of Bonds
In financial jargon, what has just been described is called interest rate risk: how much the variation in market interest rates can affect the price of a bond. In general, the longer the maturity of the bond, the more pronounced this risk is. Buying long-term bonds in recent years, with the observed increase in rates between 2022 and 2023, has generally turned out to be a bad deal, and this has certainly not spared bonds reserved for small investors. However, the damage has not been equal for everyone. For example, BTP Italia issues before the inflation boom in 2021-22, being inflation-indexed bonds, have maintained a more attractive price due to the capital and coupon adjustment to the increased cost of living.
In general, inflation-indexed bonds have less sensitivity to interest rate risk because the movement of rates in many cases (but not always) is determined following the movement of inflation – just as happened in the past year. However, rates can also increase for other reasons: for example, because the solidity of the country that issued the debt deteriorates, undermining its ability to repay creditors – as happened in Greece in 2011.
One way to reduce interest rate risk is primarily to purchase short-term bonds, which are less risky and usually less remunerative. At this stage, how should bond investments be distributed: is it better to focus on the short term, or could it be a good time to return to long-term bonds, hoping that rates will fall?
“Short-term rates are an opportunity that is difficult to ignore, but other components now highlight certain returns on medium-term maturities with limited risks,” said Luca Mainò, founder of Consultique Scf, to We Wealth. “One component is that of short-term bonds (government bonds within 12-18 months) but also, for example, of money market ETFs, linked to official rates: this way one will remain ‘indexed’ even in case of further interest rate increases or, at worst, will continue to benefit from the current level in place.”
“For medium maturities (3-5 years), it is already possible to build a bond structure to be completed in periodic tranches and in a diversified manner. The long part is perhaps the one where there are more questions: many are already aiming for an imminent reduction in yields, but this has not yet occurred,” said the independent financial consultant. “Here accumulation could begin in some time as it appears linked to the actual occurrence of an economic weakness that is slow to manifest.”
And what about inflation-indexed bonds? “With real rates that are increasingly heading upwards, in the medium term and for capital protection, a portfolio component can find effective use in this bond segment.”
