To Hedge or Not to Hedge – Blog 3

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This blog is one of a series that explores some of the features and drivers of the term structure of interest rates and how they can influence the hedging question.

In my last blog we saw that hedging strategies will only underperform if interest rates increase by more than what is currently priced into the market. In this blog we will look at the term premium, and investor preferences when investing in fixed income securities.

Term Premium

My colleague Bob Collie has written an excellent article on The effect of the term premium in a rising rate environment. Bob’s article notes that most investors prefer short bonds over long bonds so that on balance long bond investors are rewarded more for taking the increased risk associated with their longer maturity. This is known as the term premium. The existence of a term premium affects the forward and break even path of interest rates. A term premium leads to the market pricing in a bigger increase in interest rates than is expected to occur. The term premium is a part of investment theory similar to the equity risk premium and illiquidity risk premium. The existence of term premium would lead to interest rate increases, on balance, being less than forward pricing. Historical evidence of the existence of a term premium can be seen in the forward pricing of gilt yields. Figure 1 compares the change in the yield on a 2-year gilt that was priced into the market and the actual change in yield that subsequently occurred. The red breakeven line separates those data points where the actual change in yield exceeded the forward pricing from those where it did not. As seen from the graph the majority of data points lie under the line meaning that in the majority of cases yields did not increase as fast as forward pricing. Whilst we may expect yields to rise faster than forward pricing, historically this has not been the case.

Figure 1: Historical evidence of the term premium

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Source: Bloomberg. Date as of 30 June 2015.

This represents evidence in favour of the existence of a term premium. The existence of a term premium would mean that on balance, one should expect interest rate increases to be lower than forward pricing. Next we will look at carry and the cost of waiting to hedge.

 

Crevan Begley, Client Strategy & Research, EMEA

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