One eye on interest rate, one on inflation

The prices of almost all goods - except certain fruits, such as rambutan - have risen at alarming rates, thanks largely to spiralling prices of assorted commodities, specifically oil and agricultural goods.

Therefore, the Bank of Thailand (BOT) has reason to tweak its policy interest rate higher in the face of cost-push inflation. Many analysts expect the central bank to raise its policy interest rate this year. It is simply a matter of when.

Frederic Neumann, an HSBC economist in Hong Kong, said the BOT would most likely start with a 25-basis-point increase in the third quarter and another, totalling 50 basis points, by the end of the year. That would give a policy interest rate of 3.75 per cent by December.

So how should investors in bonds and bond funds adjust their portfolios? After all, hikes in interest rates are a major risk to investors counting on returns from bonds.

Long appreciated for their sure and steady returns, bond prices decrease when interest rates go up, and unless you plan to hold your bonds until maturity, that will affect your investment.

For investors in bond funds, the fund managers will already have done most of the legwork.

Kate Hathirat, head of fixed income at Aberdeen Asset Management, believes that in a rate-hike environment, bond-portfolio managers will generally reduce the overall duration of the portfolio and hold fewer bonds than a benchmark portfolio.

Duration is the most basic instrument for measuring a bond's sensitivity to changes in interest rates. If a bond has a "5.0 duration", the bond-fund yield rate will drop 5 per cent for each 1-per-cent rise in interest rates.

But Kate explained: "This does not have to mean [fund managers] will sell long-dated bonds to buy short-dated bonds. In a rate-hike environment, it is possible that long-dated bond yields do not go up, but yields of short-dated bonds do [because short-dated bond yields are most sensitive to the central bank's policy interest rate], thus resulting in capital loss when you mark to market the short-dated bonds."

Therefore, the wise portfolio manager will reduce the average duration of the portfolio rather than sell long bonds to buy short. This is not so much a loss of potential investment, because investors should be more concerned about the opportunity costs of locking their investment into bonds or bond funds of long duration. New investment opportunities may crop up. It is wise, therefore, to invest in three-month bond funds, which are now sprouting like mushrooms after a monsoon rain. Returns from these funds usually range around mid- to high-2 per cent.

Kate said investors with a large proportion of their portfolios in long-dated bond funds should unload their money into shorter-term vehicles like money-market funds, because returns on money-market funds tracked interest rate rises.

For those with only small exposure to bonds, holding onto what little fixed-income investment they have should suffice.

Kate believes if the global economy suffers a big and prolonged recession, central banks will have to cut interest rates aggressively, and bond prices will go up while those of all other asset classes will come down.