Understanding your Fixed Interest Portfolio - Part 2
Dealing with Rising Interest Rate Concerns
The Reserve Bank of Australia (RBA) uses monetary policy, or changes in interest rates, to manage the economic prosperity of Australia. Over the past 30 years, the primary goal of monetary policy has been to keep inflation within a range of 2% to 3%.
Maintaining a low-level of consistent inflation is good because:
Consumers expect pricing to gradually rise each year, which results in a benefit to buy now rather than later. This increases short term demand and enables stores to sell more and factories to produce more, which supports growing employment and wage rises.
It removes the risk of deflation. When prices fall, people defer purchasing decisions to see if prices will drop further. This reduces demand, so factories produce less, and workers may be laid off. Deflation is more destructive to economic growth than inflation.
The graph below shows how the RBA has reduced its Cash Rate over the past 30 years. The Cash Rate is the interest rate on unsecured overnight loans between banks in Australia. It is the benchmark almost all interest rates on bonds are compared against.
At present, the RBA Cash Rate is 0.10%. This indicates the economy is close to being in a deflationary environment, which the RBA wants to avoid. Thus, encouraging mild inflation is an objective of the RBA.
In Part 1 of this article, we explained how rising interest rates can result in bond prices falling in the short-term. Here are some points on what rising interest rates might mean for fixed interest portfolios:
Just because short-term interest rates rise does not necessarily mean bonds will underperform. In fact, looking at history, there is no consistent pattern. On some occasions, longer-term bonds have done badly; in other periods they have done well[i].
Prices are forward−looking. Forward prices (the first two elements described in Part 1) have already built-in expectations for interest rates and inflation. If expectations change, prices may change. We have already seen that future changes in rates cannot be forecast reliably.
We already have information in today’s prices to see two of the three components of returns. So, we can use those to decide where to invest along the yield curve without making forecasts.
Interest rates vary around the globe. We have many yield curves to choose from and they behave in different ways. They also offer different expected returns at any given point. So, by globally diversifying we are giving ourselves more opportunities. See graph below:
For illustrative purposes only.
Ultimately, how an investor reacts to the possibility of rising interest rates comes down to their investment strategy. If the main goal is capital preservation, then the choice might be to stay in short−term high−quality bonds.
If the investor is willing to tolerate more volatility for the prospect of higher return, then they may be willing to increase their exposure to the term and credit premiums. Even if there is a short-term capital loss, i.e., the capital value of the bond falls from $100 to $98 to reflect higher yield requirements by other investors, the investor can hold the bond to maturity at which time they will be paid the $100 face value.
An alternative to using bonds could be to use term deposits. Whilst the yield or return of a term deposit is known upfront, there is no possibility of capital appreciation (or loss), and there is no liquidity unless you hold the term deposit to maturity or accept a penalty to break the deposit. The investor is also exposed to the credit risk of a single institution rather than holding a diversified portfolio of bonds.
Bonds historically offer a higher expected return to term deposits. At present, CBA offers retail investors 0.35% pa for a five-year term deposit. In comparison, the yield on five-year bonds issued by CBA into the bond market are yielding 2.6% pa.
Investing in bonds versus term deposits offers investors higher expected returns and better liquidity at the expense of potential volatility, but we can manage this.
Why we 100% hedge global bond portfolios
Currency hedging is designed to reduce the impact of exchange rate fluctuations on investments traded in foreign currencies.
Equity portfolios we implement for clients typically hedge between 0% and 50% of the international share portfolio, with the percentage determined on a case-by-case basis to reflect the clients’ needs. For global fixed interest portfolios, we 100% hedge the entire portfolio for all clients.
We do this because currency returns are more volatile than investment grade fixed interest returns. So, if the currency exposure is unhedged, the currency will dominate the volatility in a fixed interest portfolio. This is shown in the graph below which compared the return of hedged and unhedged bonds.
Source: ‘Currency hedging’ by Bhanu Singh PhD, Dimensional, July 2015
In contrast, hedged and unhedged equity returns are similar from month to month, so the cost of implementing a hedging strategy in a share portfolio is less justified.
Summary
Questions about rising interest rates and what they might mean for global bond portfolios are regularly posed by our clients.
We have set out a framework in this two-part article to help communicate the concepts around fixed interest investment, starting with the principles of what bonds are, how they compare with shares, where their returns come from and what purposes they serve for investors.
We have shown what we know and do not know about bond returns and how we can use the information in prices to build a variety of solutions to help clients secure the goals they are seeking, whether it is capital preservation, diversifying a balanced portfolio or seeking higher expected returns through exposure to term and credit.
Our approach uses the information in prices, avoids the unreliable method of trying to forecast interest rates and focuses on all the things we can control, like global diversification and varying our exposure to the term and credit premiums.
Author: Rick Walker
[i] ‘Bonds and Rising Interest Rates’, Dr Steve Garth, Dimensional, December 2015