Brace yourself for rising interest rates
Australian investors are being warned that they risk being caught off guard if they are not prepared for interest rate hikes.
Franklin Templeton Investments director of Australian fixed income, Andrew Canobi, said investors needed to implement strategies that take the increasing divergence of Australian monetary policy from that of the US into account, and prepare the fixed-income portfolios accordingly.
"Australian bonds have historically had a reasonably high correlation to movements in US yields, and volatility in global bond yields will likely challenge traditional Australian bond investors with long duration exposures," he said.
"The potential bond portfolio losses from a rise in yields are further exacerbated by the market's high levels of sensitivity to changes in interest rates.
"Whilst yields could decline further and stay low for a period, the income generating qualities of government bonds has largely evaporated in recent years making continued outperformance almost entirely dependent on yields continuing to drop to new lows.
"Importantly, these short-term capital gains could be just as rapidly given back if yields reverse their downward direction".
Canobi warned that strategies that rely solely on riskier credit securities may face challenges in 2016, with risks associated with mergers and acquisitions rising and commodity prices remaining under pressure.
"Select opportunities in non-government debt will be strong, as the recent widening in spreads has meant otherwise relatively low risk entities are now compensating investors exceptionally well to take credit risk, but careful security selection has never been more essential," he said.
"We believe that investment approaches focused on shorter but dynamic duration management as well as judicious credit security selection may still deliver attractive returns above cash.
"Whether we have seen the low in Australian bond yields will likely be determined by what's happening in the domestic economy, as well as actions from the Reserve Bank of Australia (RBA). We could see the RBA act on its easing bias and lower the cash rate, but the RBA is clearly only prepared to act on this bias if conditions deteriorate."
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