Executive Summary
When investors think an economy has reached the high or low point in the economic cycle are crucial times to rethink the emphasis of your portfolio allocation. The high point in the cycle means the next expected interest rate movement will be a cut as the RBA will have slowed growth sufficiently so that inflation, amongst other measures, is contained. These points are difficult to determine, so we would always suggest investors hold all three main types of bonds: fixed rate, floating rate and inflation linked.
If investors expect lower rates in future the emphasis of their portfolio should change from floating rate notes which capture changes in interest rates by being tied to the Bank Bill Swap Rate (BBSW) and inflation linked bonds where the coupon is tied to the Consumer Price Index (CPI) to fixed rate bonds where coupons are fixed for the life of the bond.
The economy and the cash rate reach the high point in the cycle
The high point signals the likely next step in the cycle will be a fall in interest rates.
1.1. Buy fixed rate government bonds
Australian Commonwealth government and semi-government (the states and territories) fixed rate bonds are an excellent hedge in a declining interest rate environment. The Commonwealth can raise taxes and print money, so these bonds are known as “risk free”; performance is not tied to the economic cycle. Semi-government fixed rate bonds also offer a very good hedge. Investors would expect the prices of government bonds to rise, offsetting losses in assets that are linked to growth such as shares and property.
1.2. Risk off - reduce high risk corporate exposure
The risk of companies defaulting increases in a contracting economy, so sell higher risk investments in lower credit quality issuers and sell investments sitting low in the capital structure such as equities and hybrids and buy, senior secured, senior and subordinated debt.
1.3. Sell FRNs and buy fixed rate bonds
At this point in the cycle, floating rate notes should have performed the task they were designed for, that is, making sure your coupon payments reflect the market’s expectations of higher interest rates. If you expect the next interest rate move will be down, then you would sell FRNs and buy fixed. But, just as in the same stage at the opposite point in the cycle, don’t sell all of your FRNs; keep some for upside protection.
1.4. Reduce holdings of inflation linked bonds
Diversified portfolios would always have an allocation to inflation linked securities but at the high point of the cycle the risk of a spike in inflation is diminished, so sell ILBs and buy fixed rate bonds. Investors with long maturity horizons would keep a greater proportion of ILBs, given their very long terms until maturity to match future needs.
This also applies to your government holdings. Remember most government bonds are fixed, so reduce government ILBs and buy government fixed rate bonds.
1.5. Sell short dated fixed and buy long dated fixed to extend duration
In order to maximise protection for the longest time possible, sell short dated fixed rate bonds and buy longer dated fixed rate bonds. Longer dated fixed rate bonds with greater duration should show greater price appreciation.
Next week Part 5 will consider general investment and trading strategies.