Bond yields rising? It’s a good time to be an active fund manager

In 2016 the 10 year bond yields in Australia and in the US increased by over 100 basis points as inflation and growth expectations rose meaningfully, particularly following the Trump election. As yields rose when bond prices fell, these events reduced the capital valuations and performance of the benchmark1.

In America the anticipation of higher rates has proven prophetic with the US Federal Reserve (Fed) lifting interest rates in March for the second time in just over three months. The Fed has suggested there may be two more in 2017, and another three in 2018, indicating monetary policy will return to more ‘normal’ levels. In Australia, the market has removed any further rate cut expectations by the Reserve Bank and started to price in rate increases over the next two years.

In an environment of rising yields, active bond managers have the opportunity to enhance portfolio returns and protect their invested capital in ways which are not typically available to passive managers.

Manage the duration

When interest rates are falling, as they have for nearly three decades now, investors have chased higher yields by investing in longer-dated bonds. The benchmark duration increased in Australia and globally as governments were funding their current account deficits and corporates were issuing longer term maturity bonds.

Long-dated bonds, however, mean portfolios may be overexposed to interest rate duration risk. Active managers however have the flexibility to shift their portfolios to shorter duration assets (or any point on the yield curve for that matter!) to minimise capital losses.

Government vs corporate bonds

To improve the yield of the portfolios, look to investment grade credit both domestically and globally rather than long duration government bonds given the strong underlying credit fundamentals and historical low default rates in this sector.

When considering corporate bonds, as the higher income helps offset a fall in price, active managers have the flexibility to strategically position the sector exposure, cushioning the bonds from the impact of interest rate rises.

Compared to the benchmark which has had an allocation of over 50 per cent in government bonds, passive managers have had no choice but to accept higher duration risk, low risk premia and overall lower yields which has resulted in poor performance of the benchmark.

Variable investment types

Active managers also have flexibility about which financial instruments are best suited to different interest rate environments. One option available to active managers is investing in floating rate notes which have minimal duration risk. If you (or your clients) believe rates will indeed rise, a floating rate note will take advantage of these interest rate rises with minimal negative impact to the capital value of the underlying bond.

Other options not available to passive managers are investing in more complex financial instruments such as interest rate derivatives, inflation linked bonds, credit options and investing in different international markets or adding currency investments to a portfolio.

Outlook

2017 will be another challenging year for bond managers given that short and long term bond yields have been re-priced higher as markets are expecting the Fed and Reserve Bank of Australia to move cash rates higher. Bonds will always play a key role in a diversified portfolio, however in times of rising interest rates an active manager will be better placed to uncover better risk/returns.

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1 Benchmark is 50 per cent Bloomberg AusBond Composite Bond Index and 50 per cent Bloomberg Barclays Capital Global Aggregate Bond Index ($A hedged). Source: IOOF. Past performance is no indicator of future performance


At IOOF, we have positioned our portfolios to manage some of those risks and intend to continue to invest in strategies that will not only protect the capital of our investors, but continue to provide better risk adjusted returns through the use of interest rate and credit strategies that are not available to passive investors.


Return %*

Excess returns%**

Bloomberg Barclays Global Aggregate Hedged to AU$

-1.36


Bloomberg Australian Bond Index

-1.96


IOOF MultiMix Wholesale Diversified Fixed Interest Trust

0.76

2.41

IOOF Multi Series Wholesale Fixed Income Trust

0.19

1.85

* Six months ended 31 December 2016

** Compared to Trust benchmark

Important
The information contained in this newsletter is provided on behalf of the IOOF group of companies and is intended for financial adviser use only. It is given in good faith and has been prepared based on information that is believed to be accurate and reliable at the time of publication. Any examples are for illustration purposes only and are based on the continuance of present laws and our interpretation of them at the time.