Wednesday 23 March 2022 by Jonathan Sheridan Portfolio-allocations-fixed-floating-or-inflation-linked-2022 Education (basics)

Portfolio allocations - Fixed, Floating or Inflation linked?

One of our core recommendations at FIIG has been to hold a balanced portfolio of the three different coupon types – fixed rate, floating rate and inflation-linked.

In this WIRE edition we examine each bond type and why we continue to advocate for this split to enhance total return.

  • Fixed rate bonds

    Fixed coupons give investors certainty over the income generated for the life of the bond until maturity (or a reset date for callable bonds). As it says in the name, the coupon is set at the issue of the bond and accrues at the same fixed rate for the life of the bond.

    This constant rate of income therefore gives the investor confidence on the level of income to be received, and allows for easier forward planning, for example if funding expenses such as lifestyle.

    The counterpart to this income stability is the higher variation in capital price to align the total return, or yield, to the market rate. Because the income return is fixed, the only way the total yield on the bond can change to match the market at any given time is for the capital price of the bond to vary.

    This means that fixed coupon bonds carry interest rate risk, measured by the modified duration of the bond (or portfolio), which seeks to predict how much the capital price of the bond would move given a certain move in yield.
  • Floating rate bonds

    Again, as the name suggests, the income return from this bond type floats, or moves, with movements in an underlying benchmark rate. In Australia, this is typically the Bank Bill Swap Rate, or BBSW. BBSW is available for a range of maturities, from 1 month to 30 years.

    At issue, a floating rate note is issued with a coupon margin which remains the same for the life of the bond, such as BBSW plus +2.50%.  This margin is added on to the benchmark rate at each coupon date, typically quarterly, to set the total interest rate for the bond for the coming period. The margin is reflective of the credit risk inherent in the bond, so the higher the margin, the higher the risk.

    In this way the coupon ‘floats’ with the prevailing market rates. As the income return is variable and is reset each quarter, the capital price typically does not have to move as much as with fixed rate bonds for the total yield to reflect the market rate. This makes floating rate notes more stable in terms of their price than their fixed rate equivalents.

  • Inflation-linked bonds (typically called Notes)

    Inflation-linked bonds, or ILBs, are floating rate bonds that are linked directly to the CPI, rather than an underlying interest rate.

    They are the only securities that directly respond to changes in the official inflation rate, and therefore are very good at protecting purchasing power against inflation – particularly useful for investors with a fixed amount of capital, who see its value erode annually as long as inflation remains positive.
    There are two types of ILBs:

    • Capital indexed bonds (CIBs)

      CIBs increase their face value of the bond in line with the CPI index since their issue date. Therefore, unlike the previous two types of bonds, they will mature at an unknown future value subject to the level of inflation realised over their life, rather than at the par value, typically a price of 100.

      At issue the margin over inflation the bond will return is set for the life, in much the same way as the issue margin on a floating rate bond.

      The difference is that this rate is a fixed rate that is then applied to the indexed face value of the bond at each coupon period, so it is the face value of the bond that changes rather than the interest rate, as the table below shows:


    • Indexed Annuity Bonds (IABs)

      IABs work in the same way as CIBs in terms of the indexing of the interest payments, but instead of an accreting (accumulating) structure they have an amortising payment profile.

      The simplest analogy is like that of a mortgage, except from the lender’s perspective, whereby the capital paid out at the start as the investment is returned periodically, again typically quarterly, until all capital has been repaid and there is no lump sum to be repaid at maturity.

      Each quarterly cashflow is indexed to the CPI, and as an added benefit, cannot be less than the prior payment, even if inflation is negative for a period, unlike CIBs, where the indexed face value and associated income can reduce if inflation is negative.

      These features make IABs excellent particularly for retirement incomes, as they give a defined capital drawdown schedule which can be used to plan for the use of capital saved pre-retirement needed to fund a post-retirement lifestyle.

    So why have all three types in a portfolio?

    The answer is that fixed income, or bonds, are primarily used for two reasons:

    1. To secure an income stream
    2. To provide a stable capital performance

    Therefore, given the future direction of market interest rates is inherently uncertain, a combination of these three types of bonds provides the best method to achieve these two goals.

    If rates fall, the fixed coupon bonds proved a steady, higher than previous, rate of income. With falling yields, the price of fixed rate bonds also increases, therefore allowing the possibility of trading to capture this excess return.

    Income on the floating rate bonds will decrease, but the allocation to fixed rate bonds will compensate for this and the increased capital prices may allow for sales at higher prices to deliver a consistent total return.

    Inflation is typically lower in a falling rate environment, so ILBs will have coupons increasing at a slower rate but will behave somewhat like fixed rate bonds given their typically longer tenors and fixed CPI margins.

    If rates rise, floating rate income will also rise, fixed coupon bond prices will fall, but income will remain constant. If bond prices fall below the purchase price, then the bond can be held to maturity and (assuming capital is returned), no loss will be incurred. Maturing funds can then be reinvested at higher prevailing rates, improving portfolio income.

    Inflation is typically rising in increasing interest rate environments, so indexation of the bonds and therefore income will also rise, although the price may fall. Again, holding to maturity will mitigate this risk.

    In conclusion, having all three bond types in a portfolio is likely to give the most consistent total return in both rising and falling interest rate environments. Given future interest rate direction is difficult to predict, this is the best strategy to achieve the typical portfolio goals.

    If investors do have a view as to future rate directions, then this can be achieved by overweighting the allocation to a particular type to achieve the desired outcome, i.e. fixed rate in a falling rate environment and floating in a rising rate environment.

    Please see below our top picks in each of fixed rate, floating rate and inflation linked bonds. We do not actually have any sub investment grade floating rate nor any inflation linked bonds in USD. The inflation linked space has intermittent supply, so our recommendation there would be one of the several annuities available at a real yield greater than 1%, or Sydney Airport 2030 at a real yield around 1.70%.