Though the recent period of aggressive monetary policy easing has provided tailwinds for bonds, we can understand the concerns that investors have regarding capital preservation in a period of rising interest rates. Whilst this has the ability to cause headwinds for bond performance, there are a range of measures a manager can undertake to ensure preservation of capital as well as continued performance.

First, let’s recall what a bond actually is - when a bond is traded in the market, it consists of a promise to pay a certain amount in a stated currency at some future time. For example, the ten-year Australian government bond contract, involves a promise to make a stream of interest payments (in Australian dollars) over a period of ten years and to repay the principal sum (also in Australian dollars) at the end of that period.  The value of that contract at any point along the course of that ten year period largely depends on two things - the future buying power of the Australian dollar and the likelihood that the person making the promise will in fact carry it out.

The last time investors became concerned about the impact of rising interest rates was way back in 1994, when the Keating Labor Government and the RBA moved aggressively to reduce inflation by significantly boosting the cash rate. In a 4 month period in late 1994, the cash rate rose  by 2.75% to 7.5%, and stayed at that level for almost two years.

Whilst the RBA now acknowledges that it was too aggressive in monetary policy back then, the real damage at the time was inflicted in the sharemarket, which fell more than 20% over that period.

Most investment markets and their participants are forward looking. Bond markets are no exception. In fact, the bond markets are often looked to as an indicator of future economic conditions, with surprising accuracy. Witness the inverse yield curve (a predictor of economic recession) which persisted in the face of the Australian equity bull market, yet ultimately foreshadowed the Global Financial Crisis.

Figure 1 – As indicated above, inverse yield curves correctly foreshadowed financial slowdowns at the start of century, as well as more recently. Source: Bloomberg

What this indicates, is that central bank action, as well as broader economic and market conditions, are often already reflected in bond prices. So despite the next movement in interest rates being up rather than down, bond yields are already reflecting these expected changes, with bond prices adjusting accordingly. What can negatively impact bond prices are large and sudden unexpected movements in interest rates. As stated earlier, inflationary concerns and central bank movements are often the main culprits here. Given the delicate recovery process global markets are currently going through, combined with high unemployment and gaps between potential and actual production, it is unlikely that short to medium term inflation, and in response, central bank action, will be forthcoming.   

Notwithstanding these views, there are many tools and techniques available to the active fixed interest manager which allows them to effectively manage the portfolio during a period where interest rates begin to rise. Those investors who choose to take their exposures passively, via index funds, do not have this luxury and remain at the mercy of an index which through its structural limitations, tends to be more heavily invested in those nations which are overly indebted and are therefore more prone to rising rates.

Similarly, whilst investors may instead opt to place their money into a term deposit, they are often forgoing the opportunity to reinvest at increasing levels of yield. Putting aside the obvious drawbacks of no longer having the daily access to their money (which many fixed interest funds provide), the lack of daily marking to market can disguise what is really taking place. Whilst a three year term deposit offering 6% may look attractive today, if you lock away that money and next week/month/year that same provider is now offering 8%, the 6% you are locked in at is suddenly less attractive. So while many investors prefer longer dated term deposits for capital protection in times of rising rates, what they are not taking into account are the heavy opportunity costs such investments entail. Should these investments be subjected to daily pricing, there may actually be a decline in capital in such an environment, similar to what you would experience from the bond market.

So let’s take a look at some of the 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 manager will have a constant and steady cashflow flowing into the fund. The income stream associated with these ongoing coupon payments and bond maturities allows the portfolio manager to continually reinvest these flows into securities whose yields are gradually increasing. The outcome of this is similar to that of investing in short dated bonds – a reduction in what is known as “reinvestment risk” within the portfolio.

Figure 2 – Different maturity mixes can achieve the same duration target. In both of the above examples, the duration target of the portfolio is five years. However the “laddered” maturity profile of the first option allows for the constantly maturing bonds to be reinvested during the interim at increasing levels. Source: PIMCO

Duration Management

Duration measures the sensitivity of bond prices to changes in the levels of interest rates i.e. 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. This can be done both in absolute and/or relative terms, for those funds which are attempting to outperform a benchmark. In this instance, a fund with a duration coefficient less than its benchmark will, all other things being equal, outperform the benchmark should rates rise.  

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 counterparts. This will have the effect of reducing the sensitivity of the portfolio to interest rate changes.

• Utilise Floating Rate Notes (FRNs)

FRNs are securities which 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 some of the potential upside if rates fall. Many bank issues and corporate bonds are structured this way. An example would be XYZ Bank issuing a 3 year FRN which pays a margin of 25 basis points above BBSW. These instruments typically reset on a quarterly basis. So if the 3month BBSW today is 6%, the rate is 6.25%. In three months time if rates have moved to 7%, the bond is now paying 7.25%.

• Derivatives

Sophisticated fund managers who have robust systems in place can utilise derivatives for the purpose of risk management. There are numerous ways to manage duration via derivatives, many of which are beyond the scope of this paper, but some of the more common instruments include the following;

• 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 forecasted 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.

Figure 3: A swap is an agreement between two or more parties to exchange cash flows over a set period of time. Interest Rate Swaps remain a popular tool for the active manager to reduce risk within a portfolio.

• Futures – Futures contracts allow investors to buy and sell exposure to an underlying security. Taking the example above, an investor may sell contracts related to a long dated bond, such as a ten year US Treasury. If rates do indeed rise, then the contract seller will make money as the bonds he is required to deliver (or the contract he buys to close out his position) will have declined in value.

Sector Positioning

One other factor which is also worth mentioning is sector positioning. Investment in corporate bonds offers a “spread” above an investment in government bonds. This spread reflects the level of credit risk of the corporate in question. Typically, the spread on corporate debt increases as economic conditions deteriorates, reflecting the increased risk of defaults.

However during times of economic strengthening, the opposite is usually true. Improved corporate outlooks and increased risk appetites typically drive spread levels tighter, resulting in capital appreciation to the bond holder. The offshoot of this is that select corporate bonds in fundamentally sound companies will often improve in price as economic growth improves – a point in the cycle that is typically accompanied by increasing rates. An allocation to these bonds can neutralise the effects of a rising rate environment.

Summary

While the price of a bond may decrease if interest rates were to suddenly and unexpectedly rise, the very nature of fixed interest investing means that there is no physical loss of capital unless you were to 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 its maturity, in the absence of a default from the issuer, 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 a range of options and strategies open to them to immunise funds against a rise in the general level of interest rates. An active approach is essential to both protecting and enhancing client portfolios when market conditions are not always favourable. Active management can assist clients in avoiding securities which are fundamentally overpriced, as well as issuers who are overly indebted, as well as take advantage of attractive opportunities as they arise.

To achieve these goals consistently, a firm requires a depth of resources capable of conducting detailed macroeconomic and corporate analysis, and which operates within a strictly monitored risk management framework – All key areas in which PIMCO continues to devote resources.