Managing the impact of rising rates and increasing inflation on fixed income investments and fixed income portfolios.
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, one in which inflation and interest rates are rising for the first time in many years.
Advisers and investors have long enjoyed the capital stability and predictability of returns that fixed income can deliver. However, during a prolonged period of low to negative rates, the ability of some fixed income investments to deliver returns, particularly income, has been challenged.
The landscape is changing again. Now that the inflation genie is out of the bottle, and interest rates are starting to move upward, can fixed income still be relied upon in the current environment?
The current environment
Interest rates
According to fixed income specialists Payden & Rygel (Payden), the path of least resistance for interest rates in developed markets is higher over the next 12 months. This view is predicated on a sharp recovery in the labour market, combined with above trend levels of inflation and growth likely persisting throughout 2022.
In addition, the firm believes the reduction in quantitative easing by developed central banks, such as the US Federal Reserve, removes a persistent source of demand in the bond market, which is likely to put incremental pressure on interest rates.
US interest rates have risen over the last two to three months as the market has priced in multiple hikes from developed market central banks. In addition, the shape of the yield curve has flattened in developed markets like the United States and Australia, which Payden believes will limit the degree in which interest rates can rise on a sustained basis.
Conversely, developing economies have experienced significant interest rate hikes over the last 12 months in an effort to combat inflation, something likely to result in diverging interest rate paths when comparing emerging markets to developed markets.
Inflation
Inflation has been more elevated and persistent than expected over the last 6-12 months across developed markets and is currently the primary area of focus for central banks, particularly the US Federal Reserve.
Payden believes central banks, such as the Federal Reserve, are behind the curve and have likely waited too long to increase interest rates. This is substantiated by current market pricing and expectations. As a result, it’s likely that central banks will take steps to increase interest rates in such a way that seeks to meaningfully reduce inflation.
Such a move creates uncertainty in the bond market around timing and magnitude with respect to the path of interest rates, which increases volatility and the amount of risk premium required in equity and credit markets.
Fixed income – the 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 environment, one in which persistent long-term low interest rates are starting to rise, investors should be aware of the potential risk posed by longer duration assets.
When assessing fixed income investments, advisers should look for those with low sensitivity to interest rate movement, those with the bulk of interest rate exposure in the front-end of the maturity spectrum. In other words, those portfolios with shorter duration assets.
By way of example, figure one depicts the portfolio duration of the Payden Global Income Opportunities Fund at end February 2022. This absolute return strategy has the majority of its holdings in securities with a duration of 0-3 years to minimise the portfolio’s exposure to interest rate sensitivity in a rising rate environment.
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[1].
As illustrated in figure two, there are three main of yield curve shapes: normal (upward sloping curve), a flat curve and inverted (downward sloping curve).
- 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.
- 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.
- 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.
Ratings
Fixed income securities are generally rated by one (or more) of three independent rating services such as Standard & Poor’s, Moody’s, or Fitch Ratings Inc. These ratings agencies evaluate the issuer’s financial strength, or its ability to pay a bond’s principal and interest. They typically assign a letter grade to fixed income securities that indicates their credit quality as illustrated in figure three.
Investment grade bonds are assigned:
- AAA to BBB ratings from Standard & Poor’s
- Aaa to Baa3 ratings from Moody’s.
Junk bonds, or non-investment grade issues, carry lower ratings; figure three provides an example.
Generally, the higher a security’s rating, the lower the interest rate; this is why government bonds typically pay a lower rate of interest than corporate bonds or non-investment grade issues.
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 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 generally not 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. As interest rates around the world increase, exposure to long duration assets is expected to be detrimental to total returns.
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 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. And, as with passive funds, exposure to long duration assets is not the best position for investors as interest rates start to climb.
Any strategy that mimics an index will share the characteristics of that index. In an environment with rising bond yields, rising inflation, volatility and a high degree of geopolitical 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 when interest rates are rising.
In the current environment, careful thought around sector selection and credit underwriting is paramount. Payden considers select portions of the bond market will continue to benefit from rising inflation; for example, energy and real assets such as residential and commercial mortgage credit. In addition, floating-rate and short maturity fixed income securities will provide insulation from persistent inflation when compared to longer maturity, fixed rate securities.
As markets move to tighten monetary policy, it’s a good time to review your clients’ fixed income exposure. As bond yields increase, traditional fixed interest portfolios will likely experience a corresponding fall in capital 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 duration issues
- actively selects issuers that will add value to the portfolio
- can embed additional yield for investors
- focuses on positive returns.
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. 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 rates are rising.
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