This year has seen the largest increase in global inflation since 1980 when the OPEC oil shocks in the late 1970s caused inflation to reach over 14% in the US and above 10% in Australia.
Inflation is generally regarded as damaging to holders of cash and cash equivalent securities such as fixed-income products because their value or income received usually does not keep pace with the increased cost of goods and services. As a result, central banks hike interest rates to curb inflation. In the early 1980s the US fed funds rate peaked at 20% whilst in Australia the RBA cash rate and the 90-day bank bill rate both reached 22%. In response to this year’s inflationary breakout, we have seen the swiftest and largest series of central bank interest rate increases that now surpass the 1994 central bank rate hikes. To put this into an Australian perspective, at the end of the September quarter of last year, the RBA cash rate stood at 0.10%. A year later, towards the end of September 2022 and the rates had moved dramatically higher to an RBA cash rate of 2.35% (currently 2.85%). As a result, we have seen absolute negative returns for many fixed-income indices and products for the first time since 2008.
During a period of rising interest rates fixed-income investments that pay a fixed rate of interest, such as bonds, are not helpful for two reasons: firstly, there is an inverse relationship between a bond’s price and its yield – as interest rates increase, bonds fall in value, so bondholders can face capital losses but only if the bonds are sold prior to maturity. Secondly, the income coupon stream from fixed-rate bonds remains the same until maturity so no increase in income which occurs with floating-rate securities.
In contrast, investments that pay a variable or floating rate of return are likely to be better off in an inflationary environment, as the interest rate they pay is adjusted periodically to reflect market rates. If interest rates rise, the interest paid by the investment should also increase. Investors in these types of securities and products do like interest rate hikes as they have very little interest rate duration risk. Therefore, Lonsec believes a diversified portfolio of fixed-income strategies with a time horizon over 3 to 5 years should include both fixed and floating-rate strategies to reduce the impact of market volatility over time. Because at different stages of the investment cycle you will require both fixed and floating debt securities and products.
Lonsec recently took advantage of the rise in interest rates and higher yields to increase exposure to Fixed Income from underweight back to a neutral position. This was at the expense of Global Equities and Infrastructure. The reason for this move was that fixed-income fund managers can now buy debt securities at much lower prices than last year which over time to maturity will see a greater capital gain potential (positive returns) as the yield to maturity is now significantly higher. In addition, the US Federal Reserve and the RBA have both indicated that the pace of rate hikes may now slow, as they are nearer to the end of the current rate hike cycle. The impact of this will be felt next year as economic growth slows and inflation subsides to once again allow long bond yields to rally lower again even if they keep the cash rate elevated for a period.
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