Fixed vs. floating rate funds: The winner is clear

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Interest rate exposures remain an important aspect of portfolio construction.

Are floating rates sunk?

Looking back over the past 12 months, there was not a single period that floating rate credit outperformed for the year. Even ignoring fees and active performance, it is a large differential to make up even if rates do eventually rise.

 

 

Taking this further, the Table 2 shows the performance of fixed rate credit and floating rate credit since 2008. Not only has Fixed Rate Credit outperformed Floating Rate in 9 out of the past 10 years, but in the years of very poor equity market performance (2008 and 2011), fixed rate bonds saw considerably better performance.

 

 

 

Fixed rate correlation to equities – there when you need it

The role of fixed rate bonds as a diversification to equity performance can be seen below. The rolling 12-month correlation to the ASX Accumulation Index distinctly shows that while fixed rate credit can fluctuate between a positive and negative correlation, it is far more likely to offer the diversification benefits of a negative correlation compared to floating rate credit. Furthermore, in times of market stress (defined as a 5% year-on-year correction in equities) the fixed rate index typically moves to a highly negative correlation (with 2016 being the exception), compared to the floating rate index, which typically is positively correlated with equities.

 

 

It is important to note that this negative correlation for fixed rate credit is at its highest when equities are falling. When equities rise, the correlation becomes neutral to positive, so bonds shouldn’t be a drag on performance when equities are rising.

 

Credit spreads reflect the ability of a borrower to repay their debt, which means that when equity markets are doing poorly (usually when company earnings are falling and their ability to repay debt is challenged), credit spreads will widen resulting in a higher positive correlation with equities and providing little diversification. In floating rate funds there is no protection from falling interest rates, leaving investors exposed to only the widening credit spreads.

Who’s afraid of duration? (Why worrying about higher rates may do more harm than good)

The real value of fixed rate bonds as a defensive strategy comes when interest rates fall and bond prices rise. The longer the duration of the bond, the greater the benefit. Markets often misprice the likelihood of movements in rates and this is why an active manager can make a difference compared to passive strategies, which simply track market expectations. Expectations for higher interest rates in 2018 proved wrong and bond yields ended up falling back towards two-year lows as global equity markets lost value. Active managers who were able to recognise this mispricing had the potential to capture excess performance by increasing their exposure to interest rates, a strategy which was used throughout 2018 in the Nikko AM Australian Bond Fund.

By splitting bond market returns into more granular buckets, the performance of longer-dated securities, which have greater interest rate sensitivity, can be easily seen. For example, the floating rate credit index returned just over 2% in 2018 while the Australian Fixed Rate Composite Bond Index returned over 4%. However, the effects of interest rate sensitivity is more clearly seen through the performance of the ultra-long maturity Australian Government bonds (Government bonds maturing between 2039 and 2047), which achieved a 13% return despite starting the year with a yield of around 3.3%. Like most times in history, one of the best diversifiers against falling equities was to hold long duration bonds, which offer the greatest potential benefit from falling interest rates.

 

 

Conclusion

The market has been predicting rising interest rates for the better part of 10 years and this back drop has led investors to fear holding fixed rate bonds. Not only has fixed rate credit outperformed floating rate credit in 9 out of the past 10 years, it has also provided a negative correlation when investors needed it most. We believe that interest rate exposures remain an important aspect of portfolio construction and should be retained when trying to protect against negative equity performance.

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This material was prepared and is issued by Nikko Asset Management Australia Limited ABN 34 002 542 038, AFSL 229664 (Nikko AM Australia) who is the responsible entity and issuer of units in the Nikko AM Australian Bond Fund ARSN 098 736 255 (Fund). Nikko AM Australia is part of the Nikko AM Group. The information contained in this material is of a general nature only and does not constitute personal advice. It does not take into account the objectives, financial situation or needs of any individual. Investors should consult a financial adviser as well as the information contained in the Fund’s current Product Disclosure Statement (PDS) and the ‘Additional Information to the PDS’ which are available at www.nikkoam.com.au/pds before deciding to invest in the Fund. Applications will only be accepted if made on a current application form. An investment in the Fund is not a bank deposit and distributions and the return of capital are not guaranteed. Whilst we believe the information contained in this material to be correct as at the date of presentation, no warranty of accuracy or reliability is given and no responsibility is accepted for errors or omissions. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs and figures contained in this material include either past or backdated data, and make no promise of future investment returns. Past performance is not an indicator of future performance. Any economic or market forecasts are not guaranteed. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided that the positions will remain within the portfolio of the Fund.

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