Fixed Income is added to a broad portfolio of assets for several reasons. They include:

  • Return: Frequent income from the cash flows of the coupon or interest payments to stabilise the risk and return of your client’s portfolio.
  • Defensive: Capital Preservation. The relatively steady return of capital of fixed-income products (unless there is a credit event default with particular debt security) can partly offset losses from a decline in share prices.
  • Risk Diversification: Broadening the opportunity set in a multi-asset portfolio to diversify risk.

Although there are many benefits to fixed income products, as with all investments, there are several risks investors should be aware of.

  • Credit and Default Risk: Federal, State, and Semi-Government bonds and securities have the backing of the relevant Government. Whereas, corporate bonds, are backed by the financial viability of the underlying company. Should a company declare bankruptcy, bondholders have a higher claim on company assets than do common shareholders. Bonds with credit ratings below BBB are of lower quality and considered below investment grade or junk bonds
  • Interest Rate Risk: This risk happens in an environment like now whereby market interest rates are rising, and the price paid by the bond falls behind. In this case, the bond would lose value in the secondary bond market if sold or market to market on a daily basis like share prices.
  • Market Risk: The prices of bonds (like shares) can increase and decrease over the life of the bond. If the investor holds the bond until its maturity, the price movements are immaterial since the investor will be paid the par face value (usually the 100 cents in the dollar) of the bond upon maturity. However, if the bondholder sells the bond before its maturity through a broker or financial institution in the secondary market, the investor will receive the current market price at the time of the sale. The selling price could result in a gain or loss on the bond investment depending on the underlying corporation, the coupon interest rate, and the current market interest rate.
  • Inflation Risk: Inflationary risk is also a danger to fixed-income investors. The pace at which prices rise in the economy is called inflation. If inflation increases, it eats into the gains of fixed income securities. For example, if fixed-rate debt security pays a 3% return and inflation rises by 5%, the investor loses out, earning only a -2% return in real terms.

What’s Better for Fixed Income Investors when Interest Rates are Rising?

During a period of rising interest rates (yields) 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 if the bonds are sold prior to maturity. If not sold prior to maturity and they do not default, you get the original par value back plus interest.

Secondly, the income stream from fixed-rate bonds remains the same until maturity. However, as inflation rises, the purchasing power of the interest payments declines.

Investments that pay a floating rate of return are likely to be better off in an inflationary environment, as the interest rate they pay is adjusted periodically such as every 90 days to reflect market rates. If interest rates rise, the interest paid by the investment should also increase at the next reset date. Investors in these types of securities and products do like interest rate hikes as they have very little interest rate duration (or term) risk.

Inflation is generally regarded as damaging to holders of cash and cash equivalents securities or products since the value of cash usually does not keep pace with the increased price of goods and services.

Strategies Employed by Lonsec’s Managers For Diversifying Fixed Income Portfolios During a Climate of Rising inflation and Interest rates

Typically, you take into consideration the client’s return, risk, time horizon, and liquidity expectations.

Usually, such a portfolio is expected to have a minimum time horizon of three years and provide monthly or quarterly income with a level of liquidity to pay their monthly retirement benefits with minimal impact on their capital.

The anchor for the fixed income portfolio is an active fund manager with a core portfolio of investment-grade coupon-paying bonds that continually mature at par into the next series of bonds. In the current investment climate, these active managers have already taken defensive positions by reducing interest rate risk in the portfolio to below benchmark levels of duration and rotating into higher quality rated bonds.  Yes, the daily mark to market price will fluctuate and I have seen portfolios of fixed-rate bonds in some cases now down 8% over one year to the end of April 2022. However, the fixed income portfolio manager is unlikely to sell them before maturity (assuming fund flows are unchanged), and if the bonds don’t default you will get your par value principle back. As the current bond market correction continues in a typical once-a-decade event now is not the time to crystalize your mark to market paper losses. Continue to focus on your three-year strategy and the fund manager will wait for the opportune time to add interest rate risk to core bond holdings when the economic growth fundamentals start to slow and suggest inflationary pressures have peaked. By then the yields and the carry will be much higher in the portfolio.

The next part of the portfolio is your non-core strategies to enhance your income yield with some additional sub-sector strategies including credit, emerging markets, securitised assets.

Within these sub-sectors, it is important to note the following strategies. During this rate hike period floating-rate (or variable investment) strategies will do better than fixed-rate strategies as short-term rates rise due to the regular monthly or quarterly rate reset higher. Remember Floating Rate Portfolio Managers want short-term interest rates to go higher so they can pass on the higher income to their investors. Since you have a diversified portfolio of strategies this component of your portfolio will do well.

In terms of credit strategies, your typical credit manager will also be already defensively positioned. it is important in terms of capital preservation and market volatility to be higher up the capital structure in senior or senior secured debt rather than unsecured debt or hybrids. If interest rates rise too quickly and too high for an extended period, economic growth slows then the level of defaults is at risk of rising. Better to have a bias towards secured debt whereby you are protected by mortgaged assets. Also, the further up the capital structure you are the equity market beta reduces. What that means is debt lower down the capital structure usually moves in about a 0.7 correlation with equity prices. So, if equity or equities go down say 10% in price, lower down the capital structure debt such as unsecured or hybrids may go down an estimated 7% in price terms (and the reverse happens when share prices are rising and the Fund manager rotates down the capital structure). So, the credit fund manager may have added some floating-rate private secured debt or bank loans (subject to the credit rating) strategies in order to reduce the market volatility and increase capital preservation within your portfolio.

Finally, all the active strategies would be keeping up a higher-than-normal level of liquidity to quickly rotate back into higher-yielding credit and interest rate risk strategies when they deem it to be safe to do so.

Lonsec as part of our portfolio construction investment process monitors and actively manages the exposure to fixed interest assets taking into account the prevailing market conditions and risks. The current environment has been challenging for fixed interest managers; however, the market volatility will present investment opportunities and at some point, the yields offered from fixed income will warrant further investigation.


IMPORTANT NOTICE: This document is published by Lonsec Investment Solutions Pty Ltd ACN 608 837 583, a Corporate Authorised Representative (CAR 1236821) (LIS) of Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec Research).  LIS creates the model portfolios it distributes using the investment research provided by Lonsec Research but LIS has not had any involvement in the investment research process for Lonsec Research. LIS and Lonsec Research are owned by Lonsec Holdings Pty Ltd ACN 151 235 406. Please read the following before making any investment decision about any financial product mentioned in this document.

DISCLOSURE AT THE DATE OF PUBLICATION: Lonsec Research receives a fee from the relevant fund manager or product issuer(s) for researching financial products (using objective criteria) which may be referred to in this document. Lonsec Research may also receive a fee from the fund manager or product issuer(s) for subscribing to research content and other Lonsec Research services.  LIS receives a fee for providing the model portfolios to financial services organisations and professionals. LIS’ and Lonsec Research’s fees are not linked to the financial product rating(s) outcome or the inclusion of the financial product(s) in model portfolios. LIS and Lonsec Research and their representatives and/or their associates may hold any financial product(s) referred to in this document, but details of these holdings are not known to the Lonsec Research analyst(s).

WARNINGS: Past performance is not a reliable indicator of future performance. Any express or implied rating or advice presented in this document is limited to general advice and based solely on consideration of the investment merits of the financial product(s) alone, without taking into account the investment objectives, financial situation and particular needs (“financial circumstances”) of any particular person. Before making an investment decision based on the rating or advice, the reader must consider whether it is personally appropriate in light of his or her financial circumstances or should seek independent financial advice on its appropriateness.  If the financial advice relates to the acquisition or possible acquisition of a particular financial product, the reader should obtain and consider the Investment Statement or the Product Disclosure Statement for each financial product before making any decision about whether to acquire the financial product.

DISCLAIMER: No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented in this document, which is drawn from public information not verified by LIS. The information contained in this document is current as at the date of publication. Financial conclusions, ratings and advice are reasonably held at the time of publication but subject to change without notice. LIS assumes no obligation to update this document following publication. Except for any liability which cannot be excluded, LIS and Lonsec Research, their directors, officers, employees and agents disclaim all liability for any error or inaccuracy in, misstatement or omission from, this document or any loss or damage suffered by the reader or any other person as a consequence of relying upon it.

Copyright © 2022 Lonsec Investment Solutions Pty Ltd ACN 608 837 583 (LIS). This document may also contain third party supplied material that is subject to copyright.  The same restrictions that apply to LIS copyrighted material, apply to such third-party content.

Important information: Any express or implied rating or advice is limited to general advice, it doesn’t consider any personal needs, goals or objectives.  Before making any decision about financial products, consider whether it is personally appropriate for you in light of your personal circumstances. Obtain and consider the Product Disclosure Statement for each financial product and seek professional personal advice before making any decisions regarding a financial product.