Understanding your Fixed Interest Portfolio - Part 1

We are experiencing an extended period of historically low interest rates, yet there is an expectation of higher inflation later this decade – at the time of writing, ANZ’s 7-year fixed home loan rate is 7.69%.

We regularly have client discussions about investing in bonds in a low-rate environment and what an eventual increase in rates could mean for a fixed interest portfolio. This two-part article helps to address these prudent questions by explaining how the bond market works, how returns are generated and the varied purposes of fixed interest in a diversified portfolio.

Principles of Fixed Interest

Based on the decades of academic research into how public markets operate, these are the principles we apply to the inclusion of fixed interest securities in a portfolio:

Fixed interest can play several roles in a diversified portfolio, depending on the individual needs and risk preferences of the client. Commonly those needs are to reduce price volatility so people can sleep at night and provide a liquid, capital stable asset to fund cashflow needs when share portfolios inevitably experience price falls. The latter is particularly important once you have ceased paid employment.
In meeting these needs, we always start with current market prices, which contain reliable information about differences in expected returns, or ‘premiums’.
We know these premiums in fixed interest are not constant, just like the size, value and profitability premiums in equity portfolios are not constant either. The premiums vary based on market expectations and available information. This means premiums can be negative from time to time. This risk is the price investors sometimes pay for the higher expected returns offered.
Research shows bond prices, like equity prices, are largely unpredictable. So, an approach based on forecasting interest rates and what that might mean for bonds is unlikely to be reliable or robust.
We can manage these risks by diversifying globally and by varying clients’ exposure to the targeted premiums depending on their varied goals.

With these five principles in mind, we can explain how fixed interest works, the varied roles it plays, the mechanics of returns, and the tools we have available to help clients meet their goals without taking any more risk than is necessary.

Stock & Bonds are conduits for Capital

When we talk about fixed interest securities, we are normally talking about bonds. Many people understand what it means to buy a share in a company but can be confused by what a bond is.

Bonds and shares have things in common, but they also have some important differences.

In terms of similarities, they are both types of securities that companies use to raise capital from investors. They both initially are offered in a primary market and then traded in a secondary market. Their prices vary on news. And there are risks and premiums associated with both.

But they are also different. While shares are a form of ownership, bonds are a type of loan. Unlike shares, bonds are issued by governments, as well as by companies. Bonds tend to be less volatile and perform differently to shares at various times.

There are also differences within bonds. These are defined in three key ways:

Duration: This measures the sensitivity of bond prices to changes in interest rates. The higher expected returns of longer duration bonds compared to shorter duration bonds is known as the term premium. If you loan money to someone for a longer period of time, you would normally expect a higher return in exchange.
Credit: This is a measure of the likelihood of the bond issuer defaulting. For this reason, a top−rated government bond will perform differently to a low−rated corporate bond. The higher expected return associated with a lower credit quality bond is called the credit premium. Bonds with a credit rating of AAA, AA, A or BBB are considered investment grade, whilst credit ratings of BB or lower are called sub-investment grade or ‘junk’ bonds.
Note we only invest client funds into investment grade bonds.
Currency: Bonds are issued in different currencies. So, Japanese yen bonds may behave differently to US dollar or Australian dollar bonds.

The bond market is a global market about twice the size of the global share market. The US has the biggest bond market, followed by Japan, Europe and the UK. Each country's bonds perform differently depending on news and market expectations. The Australian bond market only makes up about 2% of the overall market.

Source: data from Bloomberg Barclays Global Aggregate Ex-Securitised Bond Index. As of 31 December 2020

The default rate for each investment grade of bond from 1981 to 2019 is shown below:

The last key difference is that there is more information about future cash flows from bonds than with shares. Alongside the possibility of a future capital gain or loss, bonds also offer an income stream via their coupon (this is where the term “fixed” income comes from).

Many Roles of Fixed Interest

So, all these differences mean that bonds—with their fixed income, lower volatility, and the fact that they often move differently to shares—can offer varied roles in a diversified portfolio. Broadly those roles are:

· To maximise returns via capital gain and income

· To dampen portfolio volatility, making for a less bumpy ride

· To preserve capital, and protect against the impact of inflation

· To offer liquidity or ease of access to cash if needed, particularly if share values have fallen

You can adjust the importance of each of these roles when developing a portfolio, as show below:

Mechanics of Bonds Returns

As with shares, bonds offer both income and the possibility of a capital gain. Unlike shares, where dividends can change, the income component of a typical bond is a fixed rate of interest known as the coupon.

This coupon is paid regularly until the bond matures, at which time the bond holder receives back the original loan amount, known as the principal.

Investors often do not hold bonds all the way to maturity. They buy and sell in the secondary market where the prices of bonds go up and down on news and other information.

While bonds have prices, they are most often compared by yield. The yield is the expected total return of the bond based on today’s market price and assuming it is held to maturity.

For example:

1 year Bond price - $100

Coupon - $3.00 per annum

Yield = 3.00% (being $3/$100)

Now, bond yields and prices move inversely. So, if bond prices fall, yields rise. And if bond prices rise, yields fall. Put another way, if all else is equal, the expected returns from bonds rise when their prices fall, and the expected returns fall as their prices rise. Using the example above where the bond price falls:

1 year Bond price - $98 (price is variable)

Coupon - $3.00 per annum (remains constant)

Yield = 3.06% (being $3/$98)

In another difference with shares, we can see these changing yield expectations via what is known as a yield curve. This is the curve drawn by connecting the yields of bonds of different maturities but of the same credit rating. (Using the same credit rating provides an apple with apples comparison. If you do not keep the credit rating constant, the changes in bond yields is otherwise explained by the underlying risk of the issuer).

Now, we know prices are always changing based on new information and the markets’ shifting expectations about indicators such as interest rates, inflation, economic growth and many other variables. This means yield curves are always changing shape. When yields of longer−dated bonds are higher than those of shorter−dated bonds, we get a “normally shaped” yield curve:

But at other times, curves can be flat or inverted. When they are flat, the expected returns are similar across maturities. So if you lend money to a company for 6 month or 5 years, you are getting the same return. When they are inverted, the expected return is lower for longer bonds than for shorter ones. In other words, there is no additional compensation for lending your money out for longer periods.

This means we can use the information in these yield curves to break down the sources of expected returns. On this score, there are three main elements:

Current yield is the income you receive over a specific period for owning the bond.
Expected capital gain for holding the bond for a set period based on today’s yield curve.
How the yield curve might change in the future and what that might mean for the capital gain we are hoping to achieve.

Here is an example of how capital gains in bond portfolios arise:

Now, the first two of those elements are observable, and together form what we call forward rates. In other words, they incorporate the market’s expectations for interest rates and their impact on bond yields over the coming period. We can see the income we are going to receive from the bond because we know the coupon rate. And based on market prices today, we can see the capital gain/loss we expect to receive by buying the five−year bond at a lower price/higher yield today and selling it when it becomes a four−year bond at a higher price/ lower yield.

But we also know that yields can change for various reasons, such as people’s expectations for future inflation changing. If yields go up, the yield we are receiving on our five-year bond may not look so attractive and the price may fall. The point here is that there is no way anyone can reliably predict that because the information on how the market sets interest rates is always changing.

That means we expect the contribution of this third element to be zero.

Author: Rick Walker