The global economy is recovering. GDP growth is increasing and for some regions this suggests rising interest rates – the US has already started down this path. Even so, yield levels remain low - government bond yields are anchored by central bank action. So how do investors protect against rate rises while still achieving income? In our view, the answer is simple: by constructing and actively managing a diversified bond portfolio designed to dynamically ride changes in the market.
What does this mean in practice?
From an investor's perspective, a primary objective in an inflationary environment is protection against rising interest rates while retaining the potential to generate attractive levels of income. We think exposure to floating rate bonds can offer a solution to that challenge.
Why do we like floating rate bonds? Because they have several, very specific advantages compared to their fixed rate counterparts. First up is yield. Floating rate bonds have two components to their yield. The first, the interest payment, or coupon, is based on a floating reference rate, eg Libor. This means the coupon payment is dynamically linked to interest rates. So as rates go up, cash flow rises, as rates go down, cash flow falls. Meanwhile the spread - the second component of the yield - is linked to the issuer's credit quality. The net effect is that if interest rates start to rise, floating rate bonds can offer investors a cushion against those rises because of that dynamic link between their yield and interest rates. Floating rate bonds also have one further advantage –their prices are usually less volatile than fixed rate bonds.
However, they belong to a small universe – there are only some USD 20 billion floating rate bonds in issue. So although they are fairly well diversified, with no one industry dominating that universe, credit selection is still crucial. Experienced, well-resourced portfolio management and a disciplined investment process is a must.
The other factor we mentioned was diversification. While floating rate bonds can offer that element of upside protection, we believe it's still necessary to include exposure to a range of bond instruments to minimize risks such as defaults and liquidity. Securitized bonds and derivatives are some of the investments we would typically expect to see complementing floating rate bonds within a bond portfolio. Such an approach is not without its risks – higher yield corporate bonds involve a greater issuer default risk than higher quality bonds and in a challenging market the liquidity risk could rise. But in our view, those risks are reduced by effective, active portfolio management from experienced investment specialists who can offer in-depth analysis of market developments and issuer quality alongside strong risk management.
As the macroeconomic tide turns, we believe that floating rate bonds within a well-diversified portfolio can offer investors both the protection and the income they need in an ever changing world.