Managing bond funds when interest rates are rising

Matthew McLenaghan explains how to make a bond fund perform when interest rates are rising.

The recent GFC-inspired conditions of aggressive interest rate cuts provided tailwinds for bonds, so it’s easy to understand concerns bond investors might have as rates start rising again in Australia.

However, while rising interest rates can cause headwinds for bond performance, there are measures a manager can take to ensure capital preservation as well as continued performance.

Understanding how these strategies work can provide comfort to financial advisers with clients who are invested in actively managed bond funds.

It may also provide a compelling argument for investing in bond funds rather than term deposits.

Most investment markets and their participants are forward looking, and bond markets are no exception. In fact, bond markets are often seen as surprisingly accurate indicators of future economic conditions.

Witness the inverse yield curve (a predictor of economic recession) that persisted during the Australian equity bull market, yet ultimately foreshadowed the GFC (see Figure 1).

What this indicates is that central bank activities, as well as broader economic and market conditions, are often already reflected in bond prices.

What can negatively impact bond prices are large and sudden unexpected movements in interest rates. Inflationary concerns and central bank movements are often the culprits.

There are many tools and techniques available to active fixed interest managers to effectively manage a portfolio during a period in which interest rates are beginning to rise.

Investors with passive exposures to bonds via index funds don’t enjoy the benefit of these techniques. They remain at the mercy of an index that, through structural limitations, favours overly indebted nations (which are more prone to rising rates).

Similarly, while investors may choose to put their money in a term deposit, they often forgo the opportunity to reinvest at an increasing yield.

Aside from the obvious drawbacks of no longer having daily access to their money (which many fixed interest funds provide), the lack of daily ‘mark to market’ pricing can disguise what is really happening.

While locking in a three-year term deposit offering 6 per cent may look attractive today, it will become less attractive if next week/month/year another provider offers 8 per cent.

So, while many investors prefer longer dated term deposits for capital protection in times of rising rates, they are not taking the heavy opportunity costs into account.

Let’s take a look at some strategies employed to ensure capital protection, as well as ongoing performance, in an actively managed fixed interest fund.

Maturity structuring

Rather than holding a portfolio where all the bonds contained within it mature at the same distant point in time, a portfolio manager will stagger the maturity profile of a fund. In this way, the fund will have a constant and steady cash flow.

The income stream associated with these ongoing coupon payments and bond maturities allow the portfolio manager to continually reinvest these flows into securities whose yields are gradually increasing.

This means a reduction in what is known as ‘reinvestment risk’ within the portfolio.

Duration management

Duration measures the sensitivity of bond prices to changes in interest rates (ie, the interest rate risk associated with a bond or portfolio).

By shortening the duration of a fund, the level of exposure to interest rate changes is reduced. The duration of a fund can be managed in several ways, outlined below:

• Invest in short dated bonds — by their very nature, short-dated bonds (bonds with a short timeframe to maturity) have a low duration. Investors can replace long-dated bonds, which inherently have more duration and therefore more interest rate risk, with their shorter-dated counterparts.
• Utilise floating rate notes (FRNs) — FRNs are securities that pay a fixed margin above an agreed level, such as the cash rate or, more commonly, the bank bill swap rate (BBSW). This type of instrument allows investors to avoid any downside in times of rising interest rates by giving up potential upside if rates fall. An example would be ABC Bank issuing a three-year floating rate note, which pays a margin of 25 basis points above BBSW. These instruments typically reset on a quarterly basis. So, if the three-month BBSW today is 6 per cent, the interest rate (yield) is 6.25 per cent. In three months’ time, if interest rates have risen to 7 per cent, the bond is now paying 7.25 per cent.

Derivatives

Sophisticated fund managers who have robust systems in place can use derivatives for risk management. Common instruments include:

• Swaps — interest rate swaps allow an investor to swap a fixed interest rate for a floating one. An investor who wishes to protect against a forecast rise in rates may swap out some of their fixed coupon payments for ones which ‘float’ above a certain benchmark, similar to the operation of a floating rate note (see Figure 3).
• Futures — futures contracts allow investors to buy and sell exposure to an underlying security. An investor may sell contracts related to a long-dated bond, such as a ten-year US Treasury bond. If rates do rise, then the contract seller will make money because the bonds they are required to deliver (or the contract he buys to close out his position) will have declined in value.

Sector positioning

One other factor worth mentioning is sector positioning. Investment in corporate bonds offers the investor a ‘spread’ (premium) above an investment in government bonds. This reflects the level of credit risk of the corporation in question.

Typically, the spread on corporate debt increases as economic conditions deteriorate, reflecting increased risk of defaults.

During times of economic strengthening, the opposite is usually true. Improved corporate outlooks and increased risk appetites make spreads tighter, resulting in capital appreciation to the bondholder.

Selected corporate bonds in sound companies will often increase in price as economic growth improves — a period in the cycle typically accompanied by rising interest rates. An allocation to these bonds can neutralise the effects of rising interest rates.

Summary

While the price of a bond may fall if interest rates suddenly rise, the nature of fixed interest investing means there’s no physical loss of capital unless you sell at that point in time.

Notwithstanding daily price movements which occur when marking securities to market, for an investor who holds a bond until maturity, in the absence of an issuer default, all interest payments and principal will be returned — regardless of what rates have done in the meantime.

Furthermore, the active fixed interest portfolio manager has options and strategies open to them to immunise funds against rising interest rates.

The upshot is that an actively managed approach is essential to protect and enhance client portfolios when market conditions are unfavourable.

Matthew McLenaghan is an investment specialist and the vice president of PIMCO.