Yields on government bonds in major overseas markets and Israel have surged over the past two months, especially at the long end of the curve, highlighting the importance investors should attribute to duration risk when considering fixed-income investments, and particularly at the current juncture, given bonds’ overvaluation.
Yields in major overseas bond markets are still exceptionally low across the maturity spectrum and are expected to gradually rise over the medium term, assuming the global economic recovery stays on track, particularly in the US. We therefore recommend avoiding the government bonds of the largest developed nations: the US, Germany and Japan.
Falling consumer prices in Israel are gradually giving way to a modest rise in inflation—a scenario only partially priced into local bonds at present. We consequently favor inflation-linked over fixed-rate bonds, and continue to recommend focusing on intermediate durations.
Equities remain our preferred risk asset, even though valuations are elevated by historical standards. We recommend maintaining relatively high exposure to equities, particularly overseas stocks. Moreover, the modest improvement expected in the Israeli economy in coming months argues in favor of establishing positions in local shares.
Holding cash or its equivalents is an important means of keeping risk in portfolios at reasonable levels. We recommend maintaining high exposure to this asset class as a way of offsetting the risks associated with investors’ high exposure to shares.
We continue to recommend maintaining relatively limited exposure to local corporate bonds, focusing on short to intermediate maturities of high-rated issues (A+ and above). That the rise in government yields has been accompanied by only a mild widening in spreads implies a change in attitude towards duration risk, rather than concern over the credit risk of local firms.
The risk premium on low-rated Israel corporate bonds (also known as high yield, or junk, bonds) has risen over the past six months. Given that the improvement in Israel’s economy and the low interest-rate environment reduce the risks associated with this asset class, we recommend establishing a position in these securities, as a high-risk holding. However, investors should be selective, avoiding high-yield bond indices.
The factors exerting upward pressure on the shekel versus the trade-weighted basket of currencies are likely to persist over the near term. We recommend reducing exposure to forex in investor portfolios by, amongst other means, putting hedges in place.
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