Recent spikes in domestic inflation prints, along with the sharp sell-off in longer-dated Australian government bond yields in February, has left many investors unsure what a fixed income portfolio can offer during times of inflationary pressures. Here we clear up some misconceptions about longer dated bonds and discuss the best ingredients for a fixed income portfolio.
Background
The outlook for inflation has been a hot topic of late, closely followed by the potential for central banks to return policy rates to more normal settings.
The market got ahead of itself in February this year, with the Australian Commonwealth Government bond (ACGB) 10-year yield moving ~79 basis points (bps) higher in the space of a month, as shown by the chart below. This lowered the bond’s price, keeping in mind the inverse relationship between a bond’s yield and its price: s the yield moves higher, the price moves lower, and vice versa.
The ACGB 10-year yield can be seen as a proxy for inflation expectations, with the market believing the economic recovery following COVID-19 was likely to happen quicker than first anticipated, generating inflation, and therefore sending the yield significantly higher.
Australia’s Q2 inflation print, released in late July, showed a 3.80% move higher in inflation compared to the prior year, and an increase of 0.80% higher than last quarter. The key question is will higher inflation be persistent and push central banks into action or will they be comfortable with inflation at an elevated level and the potential for markets to continue to overheat?
There is no doubt amongst the market and policy makers that inflation and interest rates need to ‘normalise’ at some point in time. We believe it’s more likely to be a matter of how much they hike by and when, not if.
So far, the Reserve Bank of Australia (RBA) and other central banks are taking a slow and measured approach, but there’s also the case for the economy recovering quicker than anticipated.
With this ongoing tug-of-war, we discuss how an investor can benefit from holding a well-constructed fixed income portfolio, including longer dated bonds, at times of inflationary pressures.
The perfect recipe
It’s worth commenting, that no matter what the outlook or ‘noise’ that can emanate during periods of volatility, it’s important to consider the overall portfolio. Just as a recipe includes many different ingredients, so too does a well-constructed fixed income portfolio, and each part will perform and respond to different markets accordingly.
One concerns amongst investors at present is what the impact will be on longer dated bonds. The longer duration a bond has, the more sensitive its value will be to changes in interest rates. As rates increase in the longer end of the yield curve, in anticipation of higher inflation and interest rate movements, then the price of longer duration bonds will tend to move lower. As above, we saw this in February, with the 10-year ACGB bond’s price moving lower, following the surge higher in its yield.
While we certainly don’t have a crystal ball and can’t predict how it plays out, we can offer our approach when it comes to portfolio construction and considerations for this ongoing debate.
We believe the recent spikes in inflation figures to be transitory, as constraints related to COVID-19 are unwound. Some of the key contributors to these higher reads include fuel, which was up 27.3% against June 2020 but only 2.7% against March 2020, remembering how low oil went in Q2 last year. Motor vehicles were also up 7.4% higher, but this is tied to supply chain issues for new vehicles, due to a shortage in electronic components.
Furthermore, we have since seen the 10-year ACGB yield creeping tighter and falling below the 1.20% level this week. As a result, the capital price on longer dated fixed coupon bonds have increased, and we believe will continue this trend for now. This will provide an attractive exit point for bondholders of longer dated fixed exposures, to take capital gains and trim positions, while also improving returns.
It is also worth mentioning that markets are forward-looking and will ‘price in’ central bank rate hikes in anticipation of them actually happening. Currently looking at the Australian Bank Bill Futures market, there is a 1% increase in benchmark rates priced in by March 2024. This means, while the RBA is anticipating rate hikes to begin in 2024, the markets are anticipating four 0.25% rate hikes to take place by March 2024.
Longer dated bonds – a key ingredient
From a portfolio construction perspective, we believe a portfolio should always have an allocation to longer dated fixed coupon bonds. The approach to lessen the exposure, is merely to adapt the portfolio in anticipation to changes in the interest rate environment.
A well-diversified portfolio should have an allocation to duration to cater for all market conditions. Longer dated bonds also round-out the maturity profile of a portfolio.
With this in mind, a key consideration for an investor is the level of income longer dated fixed coupon bonds offer and the yield when purchased, rather than the movement of the capital price until the bond either matures or is sold. The regular and known cashflows that fixed coupon bonds offer make them an attractive offering, and a core holding in a portfolio. If an investor is happy with the level of income received, then they will be less concerned with duration risk.
This also ties in with the reasons for investing; are you an investor who buys and holds until maturity, picking up the coupons along the way? Or alternatively an investor who takes advantage of windfall market moves in longer dated bond holdings and trading positions for new issues or less interest rate sensitive securities like floating rate notes?
It's also worthwhile noting the capital value of a bond is only relevant if you’re an investor who actively trades on your portfolio, or price a portfolio on a mark-to-market basis such as a portfolio manager. If the aim is to receive a regular, stable cashflow, and capital back at maturity, then the trading price is less important.
The recipe for a fixed income portfolio
While we believe it will be important for clients to lighten longer dated fixed positions, it’s also important to consider the duration of the portfolio as one of the ingredients.
A well-diversified portfolio should have an allocation to inflation linked bonds, floating rate notes and shorter dated fixed bonds. As a result, the overall portfolio’s duration across FIIG clients is generally short at less than three years on average, despite having an allocation to longer dated fixed coupon bonds.
And while we view current inflationary pressures as transitory, a fixed income portfolio offers inflation protection through the inclusion of inflation linked bonds, whereas some other asset classes offer none and returns are eroded. The returns on these inflation style bonds are adjusted for the quarterly inflation prints, and as such will increase at times of higher inflation reads.
In fact, the inflation effects will compound in inflation linked bonds, such as capital indexed bonds (CIB) and indexed annuity bonds (IAB). This means that every time there is a period of high inflation, the noteholder will reap that benefit until maturity.
If an investor holds a CIB or IAB security with a $100 indexed principal today and inflation goes up 5.00% this year, then at the end of the year, the indexed principal will have gone to $105 and for the following year, the indexation will be calculated from this adjusted higher number (i.e. $105). This improves a portfolio’s returns during times of higher inflation reads, even if the spikes prove transitory.
A range of coupon types and tenors all contribute to a well-constructed portfolio. Remember it’s the sum of the parts that are more important than the individual bonds themselves, like any well-made dish.