CPD: Fixed Income in a low rate environment

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Fixed income ETFs generally mirror a particular bond index.

Fixed income investments have long been central to a diversified portfolio. This article from GSFM explores the role of fixed income in the current environment.

Diversification is a central tenet of modern portfolio theory; that is, diversification both within and across asset classes. At its simplest, the 60/40 equity-bond split has underpinned portfolios for decades; the idea being that the equity component provides growth, while the fixed income provides income and stability. Widely adopted by financial planning models, the 60/40 portfolio dates back to 1926 and has enjoyed an annualised return of 9.1%[1].

While advisers and investors like the capital stability and predictability of returns that fixed income can deliver, can it still be relied upon in the current environment? Is all fixed income created equal? Is a passive fixed income exposure preferable to an active exposure, is a traditional bond fund better placed to deliver than an absolute return fund?

Back to basics

A fixed income investment is a loan made by an investor to a government or corporate borrower. In return, the investor receives a fixed rate of interest for a fixed amount of time. Whether government or corporate bonds, shorter-dated bank bills or other forms of securitised assets, fixed income is an important source of income and diversification for investors.

One of the benefits of fixed income is that it has a natural buyer in the issuer, which is required to pay back the loan (bond) at par value – i.e. the maturity value of a bond – when it reaches its stated maturity date. This gives bonds a greater predictability of returns.

A powerful consequence of this natural buyer is that bonds that have sold off in the marketplace due to technical reasons, such as reacting to interest rate or stock market movements, will naturally ‘pull back’ to their par value as the time to maturity draws nearer.

Those securities where there is a greater risk of default (i.e. not receiving the principal at maturity) need to pay investors a higher yield to compensate them for the increased risk.

Duration

Duration is a way to measure a fixed income security’s price sensitivity to interest rate movements – the longer the duration, the more sensitive it is to interest rate movements. A fixed income portfolio’s duration is calculated as the weighted average of the individual security’s durations held in the portfolio.

Fixed income securities with longer durations generally carry more risk and have higher price volatility than bonds with shorter durations. Therefore, in an environment where interest rates are likely to rise, shorter duration securities (and portfolios) carry less risk.

Conversely, if an investor expected interest rates to fall, a bond (or portfolio) with longer duration would be preferable, because the price would increase more than bonds or portfolios with shorter durations.

Given the current low interest rate environment, investors should be aware of the potential risk posed by longer duration assets.

The yield curve

The yield curve – also called the term structure of interest rates – shows the yield on bonds over different terms to maturity. The ‘yield curve’ is often used as a shorthand expression for the yield curve for government bonds[2].

There are three main shapes of yield curve shapes: normal (upward sloping curve), inverted (downward sloping curve) and flat.

  • A normal yield curve is where short-term yields are lower than long-term yields, so the yield curve slopes upward. It shows that bonds with a longer term are more exposed to the uncertainty that interest rates or inflation could rise at some point in the future.
  • An inverted yield curve shows short-term yields as higher than long-term yields, so the yield curve slopes downward. This occurs when investors expect interest rates will be lower in the future.
  • A flat yield curve occurs when short-term yields are similar to long-term yields and is sometimes observed when the yield curve is transitioning between a normal and inverted shape.

Fixed income strategies

To be a direct investor into fixed income securities has generally been the realm of institutional or other large investors, as minimum transactions are sizable. Although technology has enabled more direct investment in some types of fixed income securities, most investors still get exposure to this asset class through a fund. The most common unlisted products can be classed as either ‘traditional’ (or benchmark aware) fixed income funds or absolute return (unconstrained and benchmark unaware) fixed income funds. Passive funds have experienced an increase in popularity, not least as a result of the increased availability of exchange traded funds (ETFs).

Fixed income ETFs

Fixed income ETFs generally mirror a particular bond index. In Australia, this would mean choosing conventional ‘high credit quality’ indices like the Bloomberg AusBond Treasury, Government or Composite indices. The Treasury Index comprises Federal Government Bonds only – all rated AAA. The Government includes Federal Government and State (Semi) Government Bonds while the Composite also includes investment grade (rated BBB- or higher) credit bonds.

For global bonds the choice is generally between Bloomberg Global Government or Bloomberg Global Aggregate – typically currency hedged back to $A. Certainly introducing currency risk to the defensive component of a portfolio is not generally regarded as prudent.

The biggest potential drawback with ETF or Index investing is that investors have to passively accept the characteristics of the index with respect to duration and / or credit quality.

Another drawback with ETFs, which is generally more apposite to corporate bond indices, is that they are issuer weighted. This means that the biggest issuer (or the most indebted) has the biggest weight in the index. Now that is not necessarily bad if that big issuer is matched by its size or ‘market-cap’ but it can also be a little counter-intuitive that the investor has the biggest exposure to biggest debtor where one might expect ability-to-pay concerns to emerge.

If an investor is invested in a credit ETF and a big issuer defaults (for example, think Enron or Worldcomm in the early 2000s), there is the potential for big drawdowns compared to an active investor who is better placed to avoid credit ‘accidents’.

This can also be relevant to investment grade global government indices; for example, Greece during the European debt crisis was downgraded to ‘junk’, which resulted in it being removed from the index. Active investors can avoid such scenarios.

This is not to say a passive fixed income investment, whether listed or unlisted, cannot play a role in a diversified portfolio; however, there are potential shortcomings that advisers and investors should be aware of.

Traditional bond funds

Traditional fixed income funds tend to employ a relative return investment strategy, one which aims to beat a benchmark index, such as the Bloomberg AusBond Composite Bond Index. When a fund is managed with reference to a benchmark, it is typically more constrained, owning similar securities in similar proportions to that benchmark.

For example, if the Bloomberg AusBond Composite Bond Index returned -10.5% over a calendar year and an investment manager achieved a -8.0% return, that manager beat the benchmark by 2.5% and achieved its investment objective. Through ‘traditional’ investment, the manager delivered a negative return … despite beating the conventional benchmark.

A market cap weighted index is an interesting snapshot of the bond market, but from an investor’s perspective, does it make sense to use a strategy that largely replicates the index? As with passive funds, relative return funds are generally exposed to fixed income securities that have the highest benchmark weighting. In other words, those that are the most indebted, which is not always a good rationale for investment selection.

Any strategy that mimics an index will share the characteristics of that index. In an environment with rising bond yields, volatility and a degree of geopolitical and interest rate uncertainty, traditional benchmark-based approaches to fixed income investment may be less effective.

Absolute return funds

The increased number of absolute return, or unconstrained, fixed income funds illustrates that investment managers are thinking about how to best position a fixed income portfolio to generate positive returns.

An absolute return investment strategy is one that is not beholden to a benchmark; rather it is designed to be better able to navigate the complexities of the evolving fixed income landscape than traditional benchmark aware bond funds.

Because such strategies are typically managed to beat a cash or equivalent benchmark, rather than a bond index, constraints around duration and sector positioning are removed. Absolute return funds typically have lower duration (i.e. are less sensitive to changes in interest rates), a good thing in times of rising rates.

By way of example, the Payden Global Income Opportunities Fund has an average portfolio duration of 0.79[3] – less than one year – so it is less sensitive to changes in interest rates than funds with a higher average duration. As highlighted in figure one, most of the Fund’s assets are shorter duration; 65 percent of the Fund’s securities have a duration three years or less, and just fifteen percent (approximately) of the portfolio is in securities with a duration of five years or more.

The defensive qualities of fixed income, such as the potential to help to preserve value, provide diversification and provide income, have made this asset class a stalwart of most investors’ portfolios.

However, as interest rates are expected to normalise and inflation rear its head over the coming years, it’s a good time to review your clients’ fixed income exposure. If interest rates rise, traditional fixed interest portfolios may see a corresponding fall in value due to the inverse relationship between interest rates and the price of fixed interest securities.

An absolute return approach to fixed income is better placed in such an environment because it:

  • removes the benchmark from the equation
  • can focus on companies/countries with the least amount of debt
  • can focus on lower durations issues
  • actively selects issuers that will add value to the portfolio
  • can embed additional yield for investors
  • focuses on positive returns.

In the current environment, advisers should be thinking about how to position the defensive part of their clients’ portfolios at a time of historically low bond yields in an environment where inflation and rate increases are on the horizon.

 

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[1] https://robberger.com/60-40-portfolio/
[2] Reserve Bank Australia
[3] Source: Payden & Rygel, as at 31 July 2021
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