Fixed income during rising rates

The risk of including fixed interest in portfolios when interest rates are set to rise can be managed and even present an opportunity for advisers, Bill Bovingdon writes.

The case for including a defensive fixed income allocation in an investment portfolio in a falling interest rate environment is compelling.

The addition of fixed income ensures diversification and management of interest rate risk, as well as cushioning the portfolio against losses if there is a downturn in equity markets.

However, despite the well-known diversification benefits, the argument for including fixed interest in client portfolios can be harder to make when interest rates are forecast to rise — a trend which threatens the value of traditional fixed interest portfolios.

But this risk can be managed, and can even present an opportunity for advisers.

Although the Reserve Bank of Australia (RBA) is leaving the door open for more rate cuts, beyond the short-term there is broad consensus that interest rates are on the way up.

Cash rates vs bond yields

There is a crucial difference between the cash rate and the bond yield curve.

Cash rates are at the discretion of monetary policy. Bond rates, however, are set by the market in response to its anticipation of what might happen to interest rates in the future.

Despite the RBA dropping rates in March and leaving the door open for further cuts, the market continues to believe that the end of future rate falls is nigh and that future interest rate rises are inevitable.

What's more, it is not only domestic policy movements that influence bond yields in Australia.

There are substantial foreign holdings in Australian Government bonds, and this has resulted in bond yields being heavily influenced by international factors (see chart below).

Aus Unity Chart 1

Currently, opposing international forces are at work. On the one hand, employment, housing and consumption in the US are stronger and the market is anticipating that the US Federal Reserve will lift interest rates for the first time in nine years before the 2015 calendar year end.

On the other hand, continued quantitative easing measures in Europe and Japan continue to drive capital across borders and assets, impacting global yields.

Long-term, however, the international economy is expected to see improved levels of growth, resulting in central banks beginning to tighten monetary policy, thus causing interest rates to rise again.

Most economists agree with the long-term view that rates have nowhere to go but up; the question is when and by how much.

For those investors who hold Australian fixed interest in their portfolios, questions surround the impact this will have on investment returns. In the past, increases in global interest rates signalled risks to the value of a traditional fixed interest portfolio.

Many investors are still haunted by the bond market experience of 1994.

In that year, aggressive monetary policy saw the US Federal Reserve raise rates by 2.5 per cent and the Reserve Bank of Australia raise rates by 2.75 per cent in a matter of months.

This action resulted in significant losses in the bond market.

Managing duration

But the risk of this loss can be managed. To effectively manage interest rate risk in a fixed interest portfolio, it is important to understand duration.

Duration indicates how much the price of a bond will likely fluctuate when interest rates change.

For example, a one per cent increase in rates when average duration is 4.5 years will translate into a 4.5 per cent capital loss.

While coupon payments received during the period will offset some of these losses, investors will still experience a total negative return.

But there is more than one way to invest in fixed interest, and flexible management of duration will minimise the risk of capital losses in a rising rate environment.

Passive and index relative funds, for instance, are likely to be hit by the full impact of the benchmark when interest rates rise.

By their very nature, they cannot alter the fund's duration exposure to minimise interest rate risk because they are aligned with the index.

In fact, the exposure that passive and index funds have to duration tends to increase in a low interest rates environment as many issuers wish to lock in lower interest rates for longer periods.

For example, Commonwealth Government bonds, which make up a large proportion of the index holdings (44 per cent as at 30 June 2015), have a residual tenor of 6.5 years, up from just over five years in 2011 (see chart below).

Aus Unity Chart 2

Essentially, the duration of the benchmark lengthens (increases) at the worst possible time for passive investors: just before rates start to rise.

However, this is not the case with actively-managed funds. Active funds, with flexible mandates, are able to shift their portfolios to short duration assets to minimise capital losses.

So the prospect of rising rates does not need to strike fear in the hearts of investors. There are many tools and techniques available to genuinely active fixed interest managers that can allow them to effectively manage their portfolios when interest rates are rising.

For example, Altius Asset Management's flexible, high conviction approach means it can add value in a rising rate environment by:

• Investing in short-dated bonds. These have a lower duration and are therefore less sensitive to interest rate changes;

• Investing in floating rate notes (FRNs). FRNs pay a fixed margin above an agreed level such as the bank bill swap rate. A FRN coupon rises with general interest rates;

• Using interest rate swaps, Altius can swap fixed rates for floating rate notes; and

• Strategically positioning the sector exposure, which is critical in a rising rate environment. Here, it is important to distinguish between rates duration and credit duration. A portfolio heavily weighted to credit duration can produce positive returns in rising rate markets. This is because corporate securities pay a spread above Government bonds, reflecting the level of credit risk of the corporate. Typically, credit spreads tighten during times of economic strength providing an opportunity for capital appreciation.

Using these strategies, it is possible to deliver positive returns for investors in sustained rising rate environments, with a far better investment outcome than if they were in cash.

In comparison, benchmark relative strategies, including some constrained active investment managers and index funds, are limited in their ability to implement these strategies effectively.

Bond markets can move fast

The low risk, conservative nature of fixed income may result in it being viewed as the stagnant, boring cousin of equities.

This may lead financial advisers and clients to believe that they can manage fixed interest themselves, or that a passive approach is sufficient.

However, few may realise just how dynamic and fast moving bond markets can be.

Movements in German bund yields in April 2015 demonstrated just how quickly capital losses can result (see chart below).

Aus Unity Chart 3`

Bund yields traded as low as 0.05 per cent in mid-April this year and hit a high of 0.799 per cent in early May.

On 29 April, the yield on a 10-year German bund nearly doubled in just a few hours. For a passive fund or do-it-yourself fixed income investor, these movements could translate to a capital loss of 5.5 per cent between 17 April and 21 May.

In contrast, an active manager can take advantage of the swings and corrections to minimise capital losses and potentially even make gains.

During the same period in April and May, Australian 10-year bonds had a corrective rally, falling from a high of 3.01 per cent to 2.8 per cent, resulting in a 1.5 per cent return (see chart below).

AusUnity Chart 4
Source: Bloomberg

Managers with a flexible mandate are able to quickly initiate a position to take advantage of the rally, and remove the position when necessary to protect against rising rates.

Fixed interest strategies

Therefore, it is important to have ready access to duration exposure in a broader portfolio context.

The purpose of duration is to act as a counter to equity markets. However, in rising rate environments, fixed income does not need to be the enemy.

By actively switching into credit strategies and floating rate notes (as examples) a manager can continue to produce positive returns.

Traditionally managed fixed income portfolios and index funds do not provide this flexibility and, we believe, may be less than ideal for investors in the current environment.

Things to think about

Some important considerations for reviewing a fixed interest strategy in light of the market anticipating increasing interest rates are:

• Is the fixed interest strategy passively or actively managed?

• What is the average duration of the portfolio and do you, or the manager, have the ability to shift to shorter duration?

• Can you, or the manager, add value by accessing the swap market, use floating rates and strategically position sector exposure?

• Does your client have sufficient Australian fixed interest exposure to balance their Australian equity allocation and exposure to Australian interest rate risk?

Bill Bovingdon is chief investment officer at boutique fixed income manager Altius Asset Management, a joint venture partner with Australian Unity Investments.

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