In Part 1 of this series, 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 now well and truly entrenched in a battle to fight inflation and stop it from taking an irreversible grip on their economies.
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, however we are also resuming our seminars on Portfolio Construction.
This intermediate level seminar looks at the types of risks you need to be familiar with when investing in bonds, which we discussed in detail recently in The Wire (which you can read here). However, it also discusses the different types of bonds available and when and how to take advantage of them along with credit ratings and capital structure, or where in the debt stack or priority list your bonds
sit. In the next edition of The Wire, I will expand on this second area of ratings and capital structure. Below I will look at the types of bonds.
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 our earlier article, 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.
In its simplest form, duration is a measurement of a bond's interest rate risk. 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 push economies into recession, by hiking rates to smash inflation. It would then be deemed necessary to cut rates in a bid to
regenerate growth once the flames of inflation have 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 Suncorp 2028c bond with a coupon of 3mBBSW+265 basis points (bps) which was issued a couple of weeks ago. The 3-month swap rate will move with market expectations,
whilst the 265bp margin will remain fixed during the bonds lifetime.
When looking at the 3-month swap rate, it’s important to understand that this is a moving market rate and will take into account market expectations of official rate movements to that point in time, as the chart below illustrates.
Many market commentators are now forecasting the Reserve Bank of Australia (RBA) will hike rates a further three times, which would see our terminal rate peak at 4.1%, which is forecast around October of this year.
For those investors who see further hikes over and above this, then weighting your portfolio to higher proportions of short-term floating rate notes is a way in which to take advantage of this. The risk here is one of opportunity lost should rates reverse
and come down faster than expected, then returns will reduce in line with a declining rate market. The opportunity to lock in fixed rate gains as discussed above will now have disappeared or be available at a less attractive rate, as the equivalent
fixed rate bond price will have increased.
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 income streams to increase in line with the underlying inflation rate.
Whilst in the current environment weighting more heavily towards Inflation Linked Bonds sounds enticing there are some key elements that makes this difficult.
Firstly, Australia has not seen any Inflation Linked Bond issuance since 2007, nor is it likely, meaning there are very few remaining corporate “Linkers” in the market.
Secondly, Inflation Linked Bonds, come in two types.
- Capital Indexed Bonds (CIBs) is where the inflation calculation is added to the initial principal. 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 a quarterly cash flow that provides a portion of both principal and interest. These will eventually pay down to $0 meaning there is no re-financing risk and you receive your
original principal gradually over the life of the bond.
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.
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.
We suggest you discuss any strategies you wish to employ with your Relationship Manager, who can talk you through further bonds to effect these strategies and what we currently have in supply.
For further information please RSVP to one of the below upcoming seminars in your state.
Link here to the registration webpage for the upcoming events.