Fixed income investments have long played an important role in a diversified portfolio. This article from GSFM explores the role of fixed income in the current environment and explains why absolute return strategies can work well for investors in an inflationary and higher rate environment.
Advisers and investors have long enjoyed the capital stability and predictability of returns that fixed income can deliver. However, like so many asset classes in the last few years, the fixed income universe has been affected by several exogenous factors: the Covid-19 pandemic, supply shocks, the Russian-Ukraine conflict, inflation. While the latter was initially deemed transitory, it has been longer lasting than anticipated and has resulted in significantly higher bond yields across the curve.
Before taking a deeper dive into the current environment, let’s examine fixed income more broadly.
Fixed income 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 issued by governments or corporates, shorter-dated bank bills or other forms of securitised assets, fixed income is an important source of income and portfolio 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 than other assets, such as equities or property.
A powerful consequence of this natural buyer is that bonds that have sold off in response to market forces, such as central bank interest rate decisions or sharemarket 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 bond’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 each individual security’s duration.
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 where years of persistent long-term low interest rates have been replaced by consistently rising rates, investors should be aware of the potential risk posed by longer duration assets.
When assessing fixed income investments during a period of rising rates, advisers should look for portfolios with low sensitivity to interest rate movement. Such portfolios will have the bulk of interest rate exposure in the front-end of the maturity spectrum as illustrated in figure one.
The yield curve
The yield curve is used to illustrate the yield on bonds over different terms to maturity.
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) 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 repay a bond’s principal and interest. The ratings agency typically assigns a letter grade to lenders and individual fixed income securities that indicates their credit quality. Figure three depicts Standard & Poor’s ratings hierarchy.
Investment grade bonds are assigned:
- AAA to BBB ratings from Standard & Poor’s
- Aaa to Baa3 ratings from Moody’s.
Non-investment grade issues, also known as ‘junk bonds’ carry lower ratings; see the ‘speculative grade’ ratings in figure three. 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 get their exposure to this asset class through a listed or unlisted fund.
The most common unlisted products can be classed as either ‘traditional’ (benchmark aware) or absolute return (unconstrained and benchmark unaware) fixed income funds. Passive funds have experienced an increase in popularity, largely resulting from the increased availability via exchange traded funds (ETFs).
Fixed income ETFs
Fixed income ETFs (and most unlisted passive funds) generally mirror a particular bond index. In Australia, this is commonly 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 with currency hedged back to $A. Introducing currency risk to the defensive component of a portfolio is generally not regarded as a prudent approach.
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 credit quality. Another drawback, 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 corporate) 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 a client 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 are better placed to 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 … but has met its objective.
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, particularly 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 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 moving higher.
Absolute return funds and the current environment
Fixed income yields are currently higher across the board; what is unique in the current environment is that higher quality bond yields are much higher relative to where they’ve been in recent years. When bond yields are lower, fixed income managers have to ‘reach’ for yield, moving further out on the curve to attain a satisfactory yield and sometimes taking on more risk. In the current environment, absolute return portfolio managers are able to benefit from the high quality investments paying a high yield at the short end of the curve.
Higher rates mean cash is a more attractive investment. Not being beholden to a specific benchmark means that absolute return managers can hold cash or cash like investments that are paying an attractive return. This same dynamic resonates with government bonds and high quality investment grade corporates; in the current environment, these instruments have reasonable yields and, as a result of yields moving higher over the last year or two, lower prices. Consequently, there is good running yield potential in much higher quality bonds relative to the last few years, plus potential price upside. Absolute return managers are well placed to take advantage of these dynamics.
A key benefit of an absolute return portfolio is being able to identify risk and swiftly take appropriate action to protect the portfolio. Being able to do this early is paramount; when things go poorly and investors are trying to exit positions at the same time, it can have negative consequences for the portfolio.
Because an absolute return fixed income portfolio isn’t managed with respect to a benchmark, there are fewer risks that need to be managed to (such as duration or liquidity risk). It provides the manager with greater flexibility and greater latitude with respect to asset class participation; all parts of securitised assets, corporate bonds, emerging market debt, developed government debt. In short, a lot of opportunity for diversification.
An absolute return approach to fixed income is better placed in the current 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 securities
- actively selects issuers that will add value to the portfolio
- can embed additional yield for investors
- actively manages risk exposure irrespective of benchmark positions
- 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 increasing bond yields in an environment where inflation remains problematic, and the direction of interest rates is uncertain.
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