Christmas decorations and offers have been in the shops for a couple of weeks now. This turns attention to the time of year and that it is a good time to look to your bond portfolio and see what has happened over the last 12 months and make some decisions about whether it is still fit for purpose.
Go back to basics
The first group of questions to answer are whether or not the portfolio still meets its purpose. Does it provide capital stability? Does it provide secure, regular income? Is the target yield still at the level required?
Movements in bond prices, particularly in the last few weeks with the market starting to price in some inflation, may have meant that the allocation to various bond types is not optimal, or at least not at the levels desired when the portfolio was set up.
Check allocation to fixed/floating/inflation linked bonds
What is your view on interest rates? This is likely to drive the mix in the portfolio of the three bond types above.
If you have a view that rates are likely to stay low for a relatively long time (such as the RBA is suggesting – to the end of 2023 or further), then short to medium term fixed rate bonds might be appropriate.
If you think that inflation is coming and the RBA will make an about turn and raise rates earlier than expected, then floating rate notes would be preferred, as their income would increase with higher shorter term market rates.
This may mean that the longer tenor bonds may actually perform in a capital sense, as most recessions in recent history have been accompanied by central banks raising rates too much and tipping the economy over. In this case, longer dated fixed rate bonds would be preferred.
If inflation is the driving force behind some or all of these moves, then of course an allocation to inflation linked bonds would be a good option, as they provide a direct correlation to the CPI.
However, as none of these are certain, our preference would be to have a mix of all three types of bond, as well as a range of tenors. In this way regardless of the direction of interest rates, and of what causes any moves, the portfolio as a whole would deliver secure income and capital stability.
The weighting to each in the portfolio may change depending on your view.
Is the yield sufficient?
Movements in yields may have affected the overall yield of the portfolio to a level that is not within the desired range. This can work both ways. If the preference is for capital security and not a high income, then with the recent increase in yields there may be an opportunity to keep a certain yield but move up the quality spectrum.
On the other side of the coin, the last 12-18 months have seen few high yield options available, and now that market is reopening there is an opportunity to switch from lower yielding bonds that have performed and take a little more credit risk to boost the portfolio yield – in a measured way of course.
Take profits/cull losers
Capital recycling is a good strategy to maximise returns from a bond portfolio. New issues are often priced with a premium to entice new buyers compared to the secondary market. Have you bought bonds that have performed in a capital sense and can be sold to lock in a gain and recycled into the next new issue offering a premium?
On the other side of the coin, are there bonds that have not performed as well as expected and upcoming opportunities look more attractive with the potential to recover said under performance?
Of course if you are confident in the ability of the issuer to pay, then holding to maturity is always a strategy - one of the key differentiating features of a bond is the maturity date – a future date when the value of the bond is known, allowing short term price movements, particularly unfavourable ones, to be ignored.
Are there issuers who are not performing and therefore represent more of a risk than was initially anticipated when purchasing the bond?
Is there a limited liquidity window to allow you to sell a bond, such as meeting a minimum parcel requirement and not being left in a position unable to be sold?
Christmas and the end of the tax year are traditionally good times to take a step back and look at the portfolio as a whole – not just in bonds but across asset classes – and see if the portfolio is still set up in the way it needs to be to deliver the results that are being sought.
This is particularly true when there has been strong price growth in equities for example, and portfolios might now be unbalanced in terms of asset allocation. Balance within asset classes is also a good thing to be mindful of, thinking about the above questions with regard to your bond portfolio.
If you need any advice as to the make up and balance of your portfolio, or how bonds could add to the risk/return dynamic of your non-bond portfolio, please get in touch with your FIIG contact.