For the first time in many years, demand for traditional composite bond fixed interest strategies is on the rise.

This corresponds with the rebasing of cash rates, as central banks globally have sought to raise interest rates to bring inflation back to a more neutral footing, Zenith head of multi-asset and Australian fixed income Andrew Yap tells Professional Planner.

“With interest rates around the world returning to levels not seen in over a decade, funds targeting a return from active duration and yield curve positioning strategies have started to catch the eye of investors,” Yap says.

“This corresponds with the view that such strategies can be effective in positioning a portfolio ahead of possible cuts in interest rates [leading to capital gains], enhancing income generation and enhancing capital preservation qualities.”

To reign in the post-Covid inflationary spike, the pace of the US interest rate hiking cycle has been the most aggressive tightening cycle ever seen in the US, points out Ron Mehmet, senior investment consultant, Lonsec Investment Solutions.

Market expectations are for the US Federal Reserve to hike again in early May. As a result, the yield curve has inverted meaning yields at the shorter end of the US yield curve (US 3-month yields are 5.14 per cent) are higher than longer-term yields (US 10-year Treasuries at 3.41 per cent), Mehmet says.

“This caused investors last year to flock to higher shorter-term floating rate funds in anticipation of higher yields,” Mehmet says.

“However, investors in anticipation of a pause in rate hikes are increasingly repositioning their investments towards bond funds, biased towards the longer-maturity part of the yield curve in anticipation of the rate hikes causing an economic slowdown which in turn may cause yields to rally lower [and bond prices to rise].”

Advice for advisers

Investing with managers that seek to implement strategies that profit from movements in interest rates is not without risk, Yap points out.

“Take for example a situation where a manager believes central banks are nearing the tail end of their interest rate hiking cycle, and as such implement a long duration position,” Yap says.

“This strategy would be rewarding if interest rates subsequently fell. However, if interest rates rose by more than market expectation, then capital losses would be recorded.”

Advisers could also implement interest rate strategies that take advantage of anomalies across a sovereign yield curve, or across markets where it is believed there exist relative mis-pricings, he suggests.

“The challenge, however, is that it’s difficult to consistently add value from interest rate strategies, reflecting the complexity of markets and the impact that behavioural elements can have on pricing,” Yap says.

Meanwhile, Morningstar director of manager research Tim Wong warns advisers to think carefully about the role these funds play in their broader portfolio.

“Our starting point is to approach fixed income strategies as diversifiers to equities, which can be especially desirable during periods of market stress,” Wong says.

“Understanding a fixed income fund’s credit quality and interest rate duration can be informative – while high grade bonds didn’t fare well as both equities and fixed income struggled in 2022, they usually offer such correlation benefits, especially now that yields have risen meaningfully.

Wong says credit-oriented fixed income strategies can play an important role in delivering a higher income stream, but investors should just be conscious that they may possess more credit and liquidity risks.

“Which can mean a more pro-cyclical leaning when risk aversion is heightened,” Wong says.

Diversification paramount

Mehmet adds that as always when it comes to investing, advisers should be wary of putting all their eggs in one basket.

“This narrows your return options and concentrates your risk particularly if an unexpected event(s) were to occur in financial markets such as the recent US regional banking crisis,” he says.

“It’s much better to focus on your client’s long-term goals such as generating income with some capital gain by adopting several different types of fixed-income strategies to diversify your risk and return.”

This could include both floating-rate debt and fixed-rate global, domestic, and emerging market bond funds which may include sovereign, corporate, securitised investment grade, and some below-investment-grade debt securities.

“That way you’re covered throughout the investment cycle, and you don’t have to tactically chop and change your portfolio as events occur, leaving it to the fund manager who is at the coal face,” Mehmet says.

Join the discussion