Bond strategies in a rising interest rate environment
Risks are increasing, with the S&P 500 near all-time highs and investors, desperate for yield, over-exposed to shares.
The most recent Australian reporting season reinforced that share prices have already factored in all of the good news and are ‘priced for perfection’.
Take JB Hi Fi, with profit up 21 per cent to $151.7m for the half year, punished after the company warned that annual profits would grow at a slower pace than its sales, with the share price down more than 8 per cent on the day of the announcement.
Clients that are overweight shares with say, an 80 per cent allocation are exposed to capital losses in the next significant correction.
Taking profits and rebalancing to include a direct allocation to more defensive corporate bonds will help preserve capital and ensure continuity in income payments.
The Australian Labor Party’s (ALP’s) recent proposal to cut cash refunds on dividends for those not paying tax reinforces the need to consider alternatives.
Corporate bonds are legal obligations of the companies that issue them – they are obliged to repay $100 face value at maturity and make quarterly or half year interest payments.
A whopping 92 per cent of the ASX top 50 companies issue bonds in 17 currencies. It’s an important global asset class that your clients should be including in their portfolios.
Throughout the economic cycle a low risk investment grade portfolio will yield one to two per cent per annum more than deposit rates. It doesn’t sound like much but two per cent on a $400,000 bond portfolio will increase income by $8,000 a year, every year.
The question then becomes, “Is now a good time to buy bonds?”
There are various types of bonds for use throughout the economic cycle.
With an expectation of rising interest rates, the strategies we would suggest are listed below:
1. Invest in floating rate notes (bonds).
Interest on ‘floaters’ is tied to three month BBSW and adjusted quarterly, keeping pace with changing interest rate expectations.
If the benchmark three month BBSW rises, so will the interest payments on floating rate notes.
Further, higher projected (forward) interest rates are already built into today’s bond prices. See below for a sample of four floating rate bonds and the forecast yields if held to maturity.
2. Consider shorter dated fixed rate bonds with less than three years to maturity.
Fixed rate bond prices typically fall when interest rates rise.
However, like the ‘floaters’, expected higher interest rates are already built into today’s fixed rate bond prices.
Shorter dated bonds are closer to maturity, so you can have a greater certainty about the company’s ability to perform in the near term and movements in the bond price will be limited as the bond will automatically trade closer to the $100 face value (pull to par) as it approaches maturity.
3. Prefer sectors that are less sensitive to interest rates.
These include energy, IT and technology. Non- cyclical infrastructure can also work.
A severe market correction will also impact bonds but to a much lesser extent.
As long as the company survives, direct bond investors will be repaid at maturity and if that bond is Australian dollar denominated, the client will always make a positive return.
Few investments offer that certainty.
FIIG Securities makes corporate bonds available from $10,000 per bond with a minimum upfront spend of $250,000.
You and your clients have control over where the funds are invested, the risks and returns you are comfortable with and most importantly receive the full benefits of direct ownership – known maturity dates where funds are returned to clients, defined income and payment dates, access to new high yield bond issues and the opportunity to make higher than expected returns.
We have data feeds with XPLAN, Class and Praemium.
Elizabeth Moran is director of education and research at FIIG Securities.
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