When rates look certain to rise, you can take advantage of your fixed interest allocation
Interview with Bill Bovingdon, Chief Investment Officer
Altius Asset Management
When interest rates are rising it is likely older lower-yielding bonds will fall in price, with the average government bond losing almost 10% of its value. Despite this, fixed interest investors can still benefit from rising rates. Bill Bovingdon explains how he manages a fixed interest portfolio when rates look certain to rise.
How can a defensive fixed interest allocation make gains in a rate rising environment?
Bill: We don’t think there will be any changes in the Australian cash rates in the near term, however the fact that interest rates are going up globally, and especially in the US, means there could be some pressure on the long end of our yield curve. So maturities of 5 to 10 years will tend to rise further so we’re avoiding those altogether.
You can take advantage of the swings and corrections in fixed interest markets to minimise capital losses and potentially even make gains. Active managers with a flexible mandate are able to quickly initiate a position to take advantage of the rally, and remove the position when necessary to protect against rising rates.
What allocation would a typical Australian investor have towards fixed interest?
The typical public offer Australian super fund probably has a 10-15% allocation, but I suspect if you looked at self-managed super it would be much lower. That is a big contrast against countries like the US where the average is 25%, and in the UK it’s up to 40%.
Australia, traditionally, has had less fixed income, primarily because it’s a younger country and had higher growth rates, but of course we are an ageing population and what may have been defensible then is more of concern now that we don’t have enough income and don’t have enough defensive assets in the portfolios.
Why is fixed interest playing such an important role in a portfolio today?
The construction of a portfolio should not be just a share portfolio or property portfolio, it’s meant to be balanced. When you are making long term investment decisions, fixed interest is really important for the defensive part of the portfolio and provides some insurance against the shares in the portfolio. Term deposits and other surrogates for fixed income don’t play quite the same role.
Why might an index or passive fund be dangerous in this current environment?
Bill: Passive portfolios have certainly had their time in the sun. Similar to equities, when the market’s strong you’re happy with a market return and it’s not so important whether you get active management. But in the context of where we are now, having just finished a 30 year bull run in bonds, it’s now really important to be active. It’s also worth noting, passive funds are obviously driven by the length of the benchmark, and benchmarks for fixed income are currently at very high levels which means there’s a lot of interest rate risk in the benchmark.
Why is duration management really important for fixed income in this rate rising environment?
Bill: Duration is one of those things that befuddles people who only look at bonds occasionally. And bond managers don’t help when they use the same word to describe two different things. Duration means the length of the maturity of the bonds held in a portfolio, but also as a measure of interest rate risk. And when you are talking about the duration that matters for an investor, it’s the interest rate risk in the index, if you are following the index - and that’s currently five years. Now the problem with that is that you’re invested in very long term securities so you can be captive to capital losses, if those interest rates rise and you’re holding those long securities.
The short duration may seem similar to cash or a term deposit, so why is it not a good idea for an adviser or investor to stay in cash or a term deposit?
Bill: Our bond portfolio currently has a duration less than one year so the maturity of the portfolio is quite short. And if you take a longer term view you would’ve seen that our portfolio actually had quite a bit of duration a few months ago where we saw some value immediately after a couple of the events of last year where there was a spike in interest rates. We can take advantage of that because we are active and can move the portfolio around from day to day. And we also avoid the pitfalls of investing in the less liquid parts of the market like term deposits.
Can advisers navigate the fixed interest markets and make decisions themselves?
Bill: An investor or an adviser making a decision once or twice a year on bonds is very unlikely to get it right. They may miss multiple opportunities to capitalise on or to protect their clients against potential capital losses so to choose a specialist fixed interest manager who is in the market every day to manage duration and be really active in the allocation of duration suits many advisers perfectly. Those that don’t enlist an active manager to manage the fixed interest portion of their clients’ portfolio, I think they look at the cost of paying fees to be in a managed fund and they don’t compare it to the hidden brokerage that they pay when they buy the individual securities, and often they’ll pay a lot more even though it is hidden than they would with the ongoing fee of active management.
How is Altius different to an index manager and a passive manager?
Bill: We have an absolute return philosophy and lots of flexibility in our portfolios. We don’t have to replicate the indexes in any way. So if we don’t like long term securities then we can hold none in our portfolio, and therefore we can concentrate on parts of the portfolio, or parts of the market we think are attractive. Right now that’s short term securities which are sheltered by having a stable cash rate and also have lots of attractive roll down opportunities as those securities move from 3-4 years down to cash, and the rate falls at an accelerated rate down to the cash rate.
What would a 1% rise in interest rates do to the capital in an index fund?
Bill: If you are looking at an average maturity of around five years that means you could lose 5% of your capital if that were to happen in a very short period of time. That’s why active fixed interest managed is so important.
Is it quite risky to invest in credit at this point in time?
Bill: I wouldn’t invest in credit, no. If you are looking for defensive characteristics in your portfolio it’s not a time to be into hybrids or into high yield or sub-investment grade. Typically when interest rates fall, people look for other income substitutes and things like a high yield, emerging market bonds, infrastructure, private equity, hedged funds, they have a lot of equity risk in them and they have a lot of illiquidity risk as well. You only really find that when equity markets start selling off and then those defensive assets that you thought were doing the job for you, you actually get a nasty surprise in that part of your portfolio too.
I think a great way for people to look at credit to conceptualise it for themselves in terms of risk is the higher grade the credit, the more it acts like a bond. Commonwealth bonds, state government bonds, supernationals, all act very similarly. Then you’ve got banks somewhere in the middle, and then you’ve got a very high yield or hybrids that act more and more like equity. So if you are in that spectrum of investing in credit, you need to again be active because there are times when you want to embrace more equity risk in your portfolio.
What makes Altius different to other fixed interest managers?
Bill: I think the flexibility and the philosophy underlying our portfolios are really what sets us apart, so we can completely divest from the bond market when we see that it’s got too much risk, we can invest in credit when we see lots of opportunities in credit, or we can be out of credit. So that absolute return and flexibility managing across the cycle and really giving the opportunity to advisers to allow a professional manager who is doing it day in and day out to make that decision, particularly between cash and bonds. And that’s really where we come in and where we’ve really added a lot of value over time. Today, we like the shorter term maturities that have been sheltered by a stable cash rate.
Regardless of where the cycle is, is Altius the manager to allocate your fixed interest portfolio to?
Bill: Absolutely. And that’s the way the investment philosophy was conceived, it wanted to be whole of cycle.
In summary, top 4 things to consider:
- Is your fixed interest strategy passively or actively managed?
- What is the average duration of the portfolio and do you, or the manager, have the flexibility to shift to shorter duration?
- Can you, or the manager, add value by accessing the swap market, use floating rates and strategically position sector exposure?
- Does your client have sufficient Australian fixed interest exposure to balance their Australian equity allocation and exposure to Australian interest rate risk?
For more information about Fixed Interest, the Altius Bond Fund or the Altius Sustainable Bond Fund, please contact your Australian Unity Business Development Manager.
You can read more about managing fixed interest in a rising rate environment, go to www.altiusassetmanagement.com.au or call 1800 649 033.
Australian Unity Funds Management Limited ABN 60 071 497 115 AFSL 234454 is the responsible entity for the Altius Bond Fund and Altius Sustainable Bond Fund. These products are managed by Altius Asset Management Pty Ltd ABN 62 148 000 355.
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