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Reasons to review your fixed income strategy

With quantitative easing being unwound and inflation at an inflection point, Mark Todd discusses why investors should examine their fixed income strategy.

As America continues its tightening bias, commentators are trying to assess the ramifications on all asset classes and all jurisdictions. The questions for some investors are how market valuations will be impacted when or if the “risk free” rate consolidates above 3% in the US.

The “risk free” rate is the yield offered by long-term government bonds; investors presume that governments will always pay their debts, so by buying government debt their investment is risk free.

There is some dispute about how “risk free” some countries are with the most recent examples of concern being Argentina and Turkey.

Another question for markets is what will be the impact of continued quantitative easing, and will consistently low rates in Japan and Europe be an anchor on American rates or will the rest of the world need to follow the Fed’s lead?

In other words, investors need to make a call on whether they think global interest rates will remain relatively low for longer or if central banks including the Reserve Bank of Australia move into a tightening cycle.

The bond market has numerous concerns, but bond markets are always worried about something!

When I speak with bond investors they are focused on:

  1. The neutral rate
  2. Inflation assumptions
  3. Duration
  4. Credit Premium

These are explained below.

The neutral rate

Analysis of what the neutral rate should be starts with gross domestic product (GDP) and inflation. The goal of a neutral rate is to ensure that short end cash rates do not stimulate or contract the activity in the economy.

The neutral rate is therefore subjective; what growth and inflation assumptions do markets assume?

Market assumptions are reflected in their respective yield curves. Figure 1 compares two risk free rates: the Australian curve and the US curve. The green line is the US curve, which graphically highlights how much higher the US rates are compared to Australia.

The bulge in the US curve is at the front; America’s Treasury is funding the recent US tax cuts by issuing short dates securities.

Clearly by the flatness of the curve the market is assuming rates over the medium term won’t be going much higher.

Figure 1 – Australian and US risk free (government bond yield) rates compared

Source: Bloomberg (as at 13 September 2018)

It is important to note markets can also get it wrong! Yield curves can quickly change if market assumptions change.


Where is it and why is it so low?

Managing inflation can sometimes be described getting sauce out of a sauce bottle and on some occasions it can be splattered everywhere!

There will eventually be numerous academic papers written on how the rise of technology combined with ageing western workforces has created the perfect platform for incredibly low inflation in the face of low unemployment in major economies.

The key measurement is wage growth. Did the global financial crisis (GFC) train management to get staff to work longer for less or do employees not test employer resolve?

QE and the ‘Internet of things’ have driven down the cost of living, so this could possibly be a stimulant for wage restraint.

This trend might be changing, the August payrolls in the US (201,000 jobs added) showed the strongest wage growth since 2009; the American worker might be striking back!

What this will mean for bond markets is that if inflation starts to develop, fixed rate bond yields will sell off (that’s the sauce splattering for you!). Accordingly, investors will want higher returns to offset the loss in real terms from inflation.


The easiest way to think about duration is to consider the longer you lend the greater the risk so the higher the required return. If rates move higher after you have invested there is an opportunity cost and an implied loss in value if you are to sell the recently acquired asset.

Figure 2 is the iShares 20+ Year Treasury Bond ETF (TLT:NAS). At the end of August investors were heavily investing in this ETF; the volumes are well in excess of historical norms.

Clearly the investors who are committing to this asset are not concerned about duration. It could be that for these investors the key factor is the absolute returns and for some it seems like getting 3% is worth significant duration risk.

Figure 2 - Flows into the iShares 20+ Year Treasury Bond ETF

Source: Bloomberg (as at 13 September 2018)

Credit premium

Credit premium is the return investors need above the risk-free rate. What rate do investors need to lend to Telstra compared to lending to the Australian Government?

The trends we are seeing in fixed income are to lend to investment grade companies and therefore achieve a higher absolute return than lending to governments. The reasons for this are twofold.

Firstly, improving economies mean businesses are more likely to be able to repay debts and secondly businesses can borrow on a floating rate basis. If interest rates move higher investors will achieve a higher cash return.

The floating rate instrument most familiar to investors are hybrids; these securities pay fixed margins above a designated rate, so if cash rates move higher investors generate an increase in cash flow.

What does it all mean?

After years of QE, investors are assessing the impact of losing the get out of jail card, responses will be unintended and varied.

Accordingly, the key considerations for investors from my perspective are:

  1. Based on what we’re seeing in markets and key economic indicators, how likely is it that inflation will increase? It may be worth investors taking the time to form a view around whether rates are going to remain relatively low or if the sauce will start to spill.
  2. Based on this view, how is the fixed income component of their overall portfolio positioned? As I mentioned, in a rising rate environment fixed rate bonds can sell off as investors shift to issues with higher yielding coupons. In such circumstances instruments linked to a floating component such as inflation-linked debt and hybrid securities will pay higher yields as rates rise and thus protect your cash flow from inflation.

Of course, it’s crucial that investors plan investment strategies around their personal needs. Factors such as duration of the investment, the rate, likelihood of repayment and your cash flow needs should be taken into account. Further, it’s also important to consider your fixed income strategy and allocation in the context of your overall portfolio.

If an investor has any doubt of how to assess the key determinants in making an investment plan then they should seek advice from a credentialed adviser.

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