Having an active approach to managing fixed income portfolios

Many investors treat bonds and the yield they offer as a ‘set and forget’ portion of their overall investment portfolio, however it is important to consider an active strategy in managing your fixed income allocation. This is especially the case at the turning of the interest rate cycle as rates begin to lower, as investors can secure higher yields which translate to capital outperformance as bond prices rise and yields lower with interest rates.

What are bonds and how do they pay?

Bonds are part of the fixed income asset class and should be included as part of any balanced investment strategy. These securities provide investors with a predictable income stream through their scheduled coupon payments along with a promise of return of capital at maturity. There are three payment mechanisms amongst bonds; fixed coupon bonds, floating rate notes and inflation linked bonds. Importantly, each type of bond payment method has potential to outperform or underperform depending on where we are in the interest rate cycle.

1. Fixed coupon bonds pay a semi-annual coupon at a fixed coupon rate set at issuance. The coupon rate on fixed coupon bonds remains the same until maturity regardless of moves in interest rates and are preferred by investors when rates are moving downwards as the fixed coupon will exceed prevailing fixed coupons on bonds being issued once interest rates have lowered.
2. Floating rate notes pay a variable interest rate that resets quarterly as they are tied to a short-term rate called the three month bank bill swap rate (3mBBSW). These notes appeal to investors when interest rates are rising or expected to rise as the coupon will periodically adjust to reflect where interest rates have moved, thereby paying a larger coupon as rates increase.
3. Inflation linked bonds either pay a coupon indexed to inflation or have their capital value indexed to inflation to protect investors purchasing power when inflation is expected to rise.

Where are we in the interest rate cycle in Australia?

Treasury yields have pushed higher in recent weeks because of stickier than expected inflation, geopolitical uncertainty in the middle east and rhetoric over rates remaining higher for longer. While timing of the next move is debated by economists, the consensus view of the major banks agree is that the cash rate will be cut in November and that 4.35% is the peak of this interest rate cycle. As investors, how can we optimise the fixed income allocation of our investment strategy to maximise return if interest rates move lower from here?

As mentioned earlier, a bond is essentially a loan made by an investor to a corporate or governmental borrower where the borrower is required to pay investors a defined return and repay the face value at maturity. However, while bonds are issued at a price of $100 and redeem at $100 at maturity, the capital value of the security varies changes over its life in line with market conditions. These fluctuations in capital value present investors with capital upside and downside in addition to their coupon distributions as bond yields and prices are inversely related. Due to this relationship, if we are confident that we have reached a peak in interest rates, then we want to increase our allocation to longer dated fixed coupon bonds to garner a higher return in a lowering interest rate environment.

What key risks are associated with fixed income investments?

1. Credit risk – Credit risk of a bond is the risk that a corporate or governmental issuer will default on their obligations and be unable to pay the interest on their outstanding debt or repay investors principal at maturity.
2. Interest rate risk – Interest rate risk is the risk of investment losses on fixed income securities resulting from an upward move in interest rates. Using modified duration, we can understand the sensitivity of a bonds price to interest rates moving upwards or downwards– i.e. the higher a security’s modified duration, the more the price will rise if interest rates are cut, and conversely the more a bond’s price will fall if interest rates rise.
3. Liquidity risk – refers to the risk that an investor may be unable to buy or sell a security at a price that is close to the true value of the asset in question in timely fashion. If a bond is illiquid and the holder needs to sell now, it is likely they may have to sell at a loss due to a lack of liquidity in the security.

Note: Given the purpose of this article is to examine how to optimise portfolios for facing a lowering interest rate environment, we will focus on liquid investment grade AUD denominated credit to limit credit risk and liquidity risk and highlight the effect of interest rates movements.

What should investors consider benefitting in a lowering interest rate environment?

We have established that bond yields and bond prices have an inverse relationship which is important in deciding how to allocate when faced with peak interest rates and the prospect of rate cuts. Interest rate cuts cause yields to drop and per the inverse relationship causes bond prices of existing securities to rise to reflect the new rates environment. Fixed coupon bond holders who have positioned prior to rates being cut will benefit as not only are they earning the fixed coupon rate of the security they hold, but the instrument itself will appreciated in value providing outperformance above the fixed yield they purchase the security at if interested in trading.

Investors should be considering adding a higher allocation fixed coupon bonds and higher yielding investment grade credit as they are likely to outperform if rates cuts eventuate. Investors can also amplify the degree of capital upside through increasing portfolio duration by adding longer dated securities which are more sensitive to rate moves and thus will increase more in price if rate cuts occur as we expect. Ordinarily, we recommend a laddered approach with a range of bond maturities to limit interest rate risk, however if we are trying to position the portfolio to benefit from lowering interest rates, then increasing the duration of the portfolio should form part of our strategy.

What Securities Are Clients Adding to Portfolios?

We continue to see strong flows in the recently issued tier 2 subordinated debt from the investment grade financial institutions along with senior secured infrastructure credit like the recently issued 10 year bond from Sydney Airport. A quick summary of five of our preferred opportunities in the fixed coupon bond space have been included below.

Summary

In navigating the shifting tides of the fixed income landscape, it becomes evident that a proactive approach is essential for maximising returns. As interest rates are poised to decline, investors are presented with opportunities to capitalise on the inverse relationship between bond yields and prices. By strategically increasing allocations to fixed coupon bonds and higher yielding investment grade credit, and extending portfolio duration, investors can position themselves to benefit from potential rate cuts. Additionally, favoured securities such as tier 2 subordinated debt from investment grade financial institutions and secured infrastructure plays like Sydney Airport continue to attract investor interest, reflecting a broader sentiment towards capitalising on favourable market conditions.

If you wish to discuss further with one of our Fixed Income experts, email our Client Services team at [email protected] and we will get back to you shortly.

This report is provided to you or made available subject to and in accordance with the Research Report Disclosure and Disclaimer, please click here for these terms and conditions. If you have any queries please contact IAM.

To join our mailing list and receive these updates via email on a weekly basis, please complete the following form: