In this article we look at how best to construct a balanced portfolio through the inclusion of fixed coupon, floating rate notes and inflation-linked bonds and the benefits each type of bond offers.
As has been widely discussed, central banks globally are now mostly claiming victory over the outbreak of inflation that occurred in 2022-2024 and are now, tentatively, starting to lower cash rates. However, there have also been the US Trade wars adding significant volatility to equity markets. There are concerns about the total indebtedness of some countries (US, Japan, France) and so although cash rates are falling, the cost of borrowing money for long periods is relatively high.
From an asset allocation perspective, bonds have once again gained favour among financial advisers seeking yield with less exposure to the volatility associated with growth assets. Yields remain high in many parts of the market though paying attention to the maturity dates of your bond investments is very important at present.
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 have mentioned in earlier articles, these bonds do come with interest rate risk. Once purchased, if interest rates continue to rise above current market expectations the price of these bonds will fall (and vice versa as the chart below shows). This affects investments where the investor wishes to leave before the maturity (or call date) of the bond.
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 enhanced yields.
It also gives investors the ability to know well in advance your coming cash flows and expected returns. This is what is also called adding duration, since you are locking in fixed returns, based on current interest rates, for a longer period into the future.
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 will continue to cut interest rates into the future now that inflation has (mostly) cooled.
One can see the obvious risks in this strategy. If Central Banks do not cut interest rates further rates might rise. 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 the rate-cutting cycle is fully complete.
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 Liberty Financial Mar-30 bond with a coupon of 3-month BBSW+205 basis points (bps) which was issued in February 2025. The 3-month BBSW rate will move up and down over the course of this bond, whilst the 205bp 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.
The general consensus in the market is that the RBA will continue cutting rates over the remainder of this year, and then stop. That is why the expected BBSW rate falls over time, then sits flat for a while. The slight rise at the end of the forecasts can be interpreted as an expectation the RBA will raise rates in 2027, though it could also be something called Term Premium.
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 (or tariff-driven 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 and final capital returns to increase in line with the inflation rate.
While the current environment with its risk of inflation might make Inflation-Linked Bonds seem 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 future inflation rates, 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 corporate Capital Indexed Bond effectively remaining on the market is the Sydney Airport 3.12% 2030 line (as the AGN August 2025 ILB will mature in ~2 months).
Trying to position the portfolio to overweight these securities can be difficult given the smaller supply and illiquidity.
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.
The current economic climate is marked by cooling inflation, rate cuts and ongoing market volatility. Based on the investor’s outlook on the markets, one can position themselves accordingly using the 3 different types of bonds highlighted in this article. Each of these types of bonds will possess different characteristics and has a place in a diversified portfolio.