We look at how best to construct a balanced portfolio through the inclusion of fixed coupon, or floating rate notes and inflation-linked bonds and the benefits each type of bond offers.
As has been widely discussed, central banks globally are well and truly entrenched in a battle to fight inflation and stop it from taking an irreversible grip on their economies. Signs are that most Central Banks are winning the fight and attention is turning to when the first-rate cuts might be possible.
From an asset allocation perspective, this has seen bonds once again find favour with financial advisers who are looking for yield away from growth assets and the volatility that asset class brings to capital balances.
Many who are regular readers of this publication will have attended one of our Introduction to Fixed Income seminars as a way of understanding the basics of the asset class.
This piece goes a step further to look at the different types of bonds available and when and how to take advantage of them.
Three Types of Bonds
- Fixed Rate Bond
- Floating Rate Note
- Inflation-Linked Bond (Capital Indexed, Indexed Annuity Bond)
Ideally, a diversified bond portfolio will utilise all three of the abovementioned bonds. However, for those wishing to enhance their exposure and take advantage of these bonds depending on the prevailing market conditions, skewing your portfolio to be weighted more heavily to one over the others is a strategy that many bond managers employ.
If we begin with a basic balanced portfolio weighting of 40% Fixed Rate, 40% Floating Rate, and 20% Inflation-Linked Bonds, investors can look to be over or underweight a bond type depending on their thinking.
Fixed Rate Bonds
The Fixed Rate Bond is the type of bond that most will be familiar with. It offers a fixed return, with a finite maturity or call date and once purchased investors will know the expected return should they hold until call or maturity. As we mentioned in earlier articles, these bonds do come with interest rate risk where, once purchased, should interest rates continue to rise above current market expectations the price of these bonds will fall (and vice versa as the chart below shows).
However, once you have assessed
this risk and have researched your own expectations of interest rate movements,
skewing your portfolio to be more heavily weighted to Fixed Rate Bonds can
allow the investor to lock in these enhanced yields.
It also gives the ability to
know well in advance your coming cash flows and expected returns. This is what
is also called adding duration.
The duration is an average of
how far into the future a bond investment has fixed returns. But locking in
fixed returns now means that the investment doesn’t gain from rises in interest
rates nor does it suffer from falls in interest rates – as long as the bond is
held to maturity. In this way, the duration is also a measurement of a bond’s
interest rate risk should investors seek to exit the investment before maturity.
Generally, the higher a bond's
duration the more its price will fall as interest rates rise; however, the
reverse is also true; should we see interest rates fall, you would achieve your
desired outcome by seeing the price of your bonds rise.
It is this scenario that many
are faced with at present, where we see an expectation that the central banks
of the world may soon begin to cut rates now that inflation has cooled.
One can see the obvious risks in
this strategy, however, should investors be comfortable with their investment
return, time horizon and credit quality it can be a great way to lock in
enhanced yields before a rate-cutting cycle.
Floating Rate Notes
As the name suggests, this type
of bond pays a coupon that fluctuates with movements in the rate market.
Typically, the 3-month Bank Bill Swap Rate (BBSW) is used with a fixed margin on top of this. This
margin is set at the original issuance depending upon credit quality and other
comparable issuance in the market. A recent example is the HSBC Mar-34 bond
with a coupon of 3-month BBSW+230 basis points (bps) which was issued in March
2024. The 3-month BBSW rate will move up and down over the course of this bond,
whilst the 230bp margin will remain fixed during the bond's lifetime.
When looking at the 3-month BBSW
rate, it’s important to understand that this is a moving market rate and will
take into account the actual cash rate at any point as well as market
expectations of any other movements in the cash rate in the future. The price
of interest rates in the market also implies the expected trajectory of the
3-month BBSW rate into the future. These expectations are forecasts and so can
be wrong – sometimes materially so.
Figure 2: 3 Month BBSW rates now, and expected into the
future
Source: FIIG
Securities, Bloomberg
The general consensus in the
market is that the RBA will begin cutting rates later this year, which is why
the expected BBSW rate falls over time.
Those investors who expect further
rate cuts over and above this market expectation should lean towards fixed rate
bonds.
However, those who fear the
market is over-optimistic about rate cuts and fear sticky inflation keeping
rates higher for longer should consider weighting their portfolio towards short-term
floating rate notes. The risk here is one of opportunity lost should the RBA
deliver more rate cuts than currently expected.
Inflation-Linked Bonds
Inflation-Linked Bonds (ILBs)
are exactly as the name describes: they are designed to keep pace with
inflation and allow your future coupon stream to increase in line with the inflation
rate.
While the current environment might
seem like weighting more heavily towards Inflation-Linked Bonds should be enticing
there are some key elements that make this difficult.
Firstly, Australia has not seen
any corporate Inflation-Linked Bond issuance since 2007. Nor is new issuance
particularly likely, meaning there are very few remaining corporate “linkers”
in the market. While the government “linker” market remains open, the yields there
are lower.
Secondly, Inflation-Linked
Bonds, come in two types.
- Capital Indexed Bonds (CIBs): the
inflation calculation is added to the initial principal. Coupons are then
paid as a percentage of this index-linked principal, meaning the coupons
are inflation-linked too in a practical sense. The indexed value of the
bond is received at final maturity, rather than the par issue value.
- Indexed Annuity Bonds (IABs): is where
the inflation return is included in the quarterly cash flow that also provides
a portion of both principal and interest. These will eventually pay down
to $0 meaning you receive your original principal gradually over the life
of the bond and do not receive a final return of capital in a lump sum.
There is also a lag effect in
the pricing of the Capital Indexed Bond where the inflation adjustment is
calculated as the average of the prior two inflation prints.
Furthermore, to take full
advantage of highly inflated markets, the investor would need to hold these
investments until maturity, and most remaining ILBs in the market have long
maturity dates to 2030 and beyond. The only two corporate Capital Indexed Bonds
remaining on the market are the Sydney Airport 3.12% 2030 and the Australian
Gas Networks (AGN) 3.04% 2025. Trying to position the portfolio to overweight
these securities can be difficult given supply, and in smaller volumes can be
illiquid. There has been a supply available of the AGN bond recently – though
that is no guarantee the supply will remain.
The chart below illustrates the
increasing indexed value of the Sydney Airport 2030 bond, as the face value of
the bond keeps pace with inflation.
Figure 3: The Capital Indexation
of the Sydney Airport Nov-30
Source: FIIG
Securities, Bloomberg