By Anthony Si, Senior Investment Specialist at Citi Australia.
We are heading into an inflationary ‘boom’ period, making investing tricky as markets react more intensely to the daily news cycle and fixed income is impacted by negative perceptions of underperformance in an expected period of rising interest rates.
There are two main scenarios under which fixed income may suffer in a rising rate environment. The first is where the interest rate you receive on your investment was set when interest rates were lower. As rates rise the return on your investment becomes less attractive. The second is where you seek to sell an instrument like a bond and experience a capital loss on the face value by selling into a rising rate environment.
However, there are always strategies to navigate changing market conditions. For bonds it’s mostly around choosing the right duration of your investment and picking the right instrument that matches your desired return and risk tolerance.
Option 1: Investment grade corporate bonds
This is a loan you make to an issuer, such as a financial institution, like a bank, or a large local or international company. You get paid regular interest payments, and at maturity the money you invested is returned.
The risk you carry is that the company gets in financial trouble and defaults on its obligations. However, investors can take comfort from knowing that the rating has been researched and issued by one or more of the three international ratings agencies.
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Investment grade bonds are generally a favoured asset class in periods of economic uncertainty, as they are not subject to the volatility of equity markets and some other asset classes. This is likely to remain the case while the cash rate remains on hold.
Instead of investing in bonds maturing in 10 years’ time, which is considered long in duration and exposes investors to the sensitivity of bond prices in a rising rate environment, our call is that it is more beneficial for investors to go for medium term tenor of 5-7 year duration. Remember, holding bonds for a period of time will reduce its remaining tenor and make it less sensitive to rate rises.
Option 2: High-yield bonds
These companies are not considered as financially robust as investment grade rated companies, and therefore you expect a higher return for your investment. The terms and conditions can also be more complex, so if you think high-yield bonds may suit your portfolio ensure you take the time to understand the risks and benefits in detail, which may entail seeking professional advice.
Investors may ask: “what if the issuers go pear-shaped”? It is the risk you carry, as shown with the high-profile case recently of Chinese property group, Evergrande. However, the global default rate for investment grade companies is only 0.02 per cent and 2.4 per cent rate for high-yield corporate bonds in the three years to December 2019, according to data from the S&P Annual Global Corporate Default and Rating Transition Study.
Option 3: Hybrid debt instrument
Compared to other forms of fixed income instruments this is the new kid on the block.
These are debt securities that possess elements of both debt securities and equities, and it creates unique attributes to this form of investment.
Financial institutions issue hybrid instruments because it may be considered as an equity instrument for accounting purposes – where the issuer increases the equity ratio without affecting the level of debt ratio.
Given the higher risk of this instrument, investors seek compensation through a higher coupon rate. The key for investing in this instrument is to pick financially sound companies with solid capital management, such as maintaining a high Common Equity Tier 1 ratio.
While not an exhaustive list, below are some of the key risks to consider:
- Have risks similar to equity investments
- May convert into ordinary shares
- Potential to be written off if the issuer experiences financial problems
- May contain terms and conditions that allow the issuer to suspend interest payments or exit when they choose
Again, ensure you are fully across the risks and benefits of these types of investments before committing your capital.
Option 4: Floating rate bonds
As we touched on earlier, a key question for bond investments is around interest rates. So, it’s likely an investor will be thinking: “What happens to my bond investment when the Reserve Bank of Australia starts to increase the official cash rate from its historical 0.1 per cent low.”
In the bond world, there is also a type of corporate bond issued with a floating rate coupon and distributions are normally on a quarterly basis. They are typically referred to as a Floating-Rate Note (FRN).
FRNs are usually a shorter-term debt instrument and may help investors get positioned for a rising interest rate environment. FRNs have a variable interest rate tied to a short-term benchmark, like the US Federal Reserve funds rate or the London Interbank Offered rate (Libor).
Typically, floating rate bonds pay a lower yield compared to fixed-rate bonds. This is because the floating rate investor is seeking compensation for any interest rate rise, and therefore gives up some yield in return for that security.
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Conclusion and considerations
Formulating and shaping a balanced fixed income portfolio will help reduce risk for investors, and keep them positioned for changing market conditions in the future.
Diversifying a portion of your funds into higher yield fixed income instruments will help to enhance returns in an ultra-low interest rate environment. It also provides options for buying international bonds to provide an exposure to sectors not available in Australia, as well as currency options to further enhance your returns.
Remember, while interest rates are a key consideration when considering bond investments, they are not the only influence to consider. Keep these points in mind when pursing a fixed income strategy:
Supply and demand: When there are many issuances on offer, investors have more choice and as with any asset this will influence their willingness to pay and thus the issuer’s pricing of the offer.
Credit quality: Bonds fall in value if the creditworthiness of the issuer deteriorates, and rises when it improves. Companies do fail, although rarely those with a top-end investment rating.
Closeness to maturity date: Bonds tend to converge to their initial face value as the maturity date approaches, which is to be expected.
Pre-maturity trading: Bonds can be bought and sold before they mature at prices other than their face value, usually either in over-the-counter markets or trading exchanges. Investors can sell bonds at a profit or loss depending on market prices or trading exchanges.
Interest rates: Most bond prices fall with rising interest rates, and vice versa. Bonds with longer terms and a fixed coupon are more sensitive to interest rate movements.
Any advice is general advice only. It was prepared without taking into account your objectives, financial situation, or needs. Before acting on this advice you should consider if it’s appropriate for your particular circumstances. You should also obtain and consider the relevant Product Disclosure Statement and terms and conditions before you make a decision about any financial product. Investors are advised to obtain independent legal, financial, and taxation advice prior to investing. Past performance is not an indicator of future performance. This document is distributed in Australia by Citigroup Pty Limited ABN 88 004 325 080, AFSL No. 238098, Australian credit licence 238098.
