For fixed income investors, predicting the interest rate cycle and bond prices can be akin to catching a falling knife, with potentially costly consequences.
“Fixed income investors don’t need to try their luck at catching,” warned Scott Rundell, chief investment officer at Mutual Limited.
In the world of investing, reducing risk without significant sacrifice is a rare opportunity.
Rundell suggested that within the fixed income space, there’s a chance to achieve this delicate balance.
While risk reduction is typically associated with lower returns, the opportunity to shift exposure from fixed-rate to floating-rate assets may lead to improved returns, depending on market conditions and factors such as bond market volatility.
This is particularly relevant in today’s fixed income landscape, where speculation abounds regarding the peaking of bond yields and interest rates. The direction of interest rates significantly affects the performance of bonds on the “fixed rate” side, but what is often overlooked is the less direct impact on the “floating rate” side of the fixed income universe.
Floating rate notes, as Rundell explained, reset their coupon rates every 90 days, offering a flexibility that fixed-rate bonds lack. It’s as if these floating rate notes can “change their clothing” to suit the weather, making them less exposed to extreme conditions.
Rundell highlighted two crucial points: first, despite the naming convention of “fixed income”, the asset class often includes both fixed-rate and floating-rate choices from the same debt issuer. Second, the relationship between interest rates and fixed income returns can introduce significant volatility, especially in traditional bond funds.
Using an example from ANZ, Rundell illustrated the performance difference between fixed and floating bonds, emphasising the inverse relationship between yields and fixed-rate bond prices. As interest rates rise, fixed-rate bond prices fall, making the floating rate note an attractive alternative for investors seeking capital stability and a relatively low-risk income flow.
In conclusion, Rundell advised caution in increasing allocations to duration risk (fixed-rate bonds) amid uncertainties about the end of the cycle.
Floating rate notes, with their ability to provide capital stability and sustainable income flow, emerge as a compelling alternative for investors navigating the evolving fixed income landscape.
