The Reserve Bank of Australia (RBA) has remained on hold since the release of a surprising benign inflation report for the March quarter.
The Reserve Bank of Australia (RBA) has remained on hold since the release of a surprising benign inflation report for the March quarter. However the persistent strong world economy, demand growth and limited capacity may still result in some upward pressure on inflation over time. In other words, another interest rate hike in the near term is not out of the question.
So what should fixed income investors do when an interest rate rise comes around the corner? According to Portfolio Partners Head of Income Lance Pupelis, the last thing investors should do is panic and give up on fixed income.
Interview with Lance Pupelis: "Let's start by quantifying what investors consider to be a significant loss. Say you buy a share for A$10 and it falls to A$5. You're probably worried - you've just lost 50% on your investment.
"However, let's say the share falls to A$9. Are you as worried? Perhaps, since you have just lost 10%. But what if it falls to A$9.50 instead? It's less worrying isn't it? Most investors would consider this to be normal fluctuation, but it still constitutes a loss of 5%.
"What's interesting is that 5% is the single biggest annual loss in any calendar year ever recorded in the Australian fixed income market. That was back in 1994 - more than 13 years ago. The second worst year was 1999, when fixed income returned minus one percent, which is similar to a A$10 share falling to A$9.90. In both instances, the RBA was in the process of a policy tightening similar to what is occurring right now.
"The thing about rising interest rates is that you will get it back over time in terms of higher running yield. Once rates fall again, and it is reasonable to assume that the RBA will not continue to lift rates forever, you get even higher returns as capital gains kick in. For instance, in 1994, fixed income returned -4.7%1. However, when rates fell in 1995, the fixed income market returned over 18%1.
"Again, in 1999, the market returned -1.2%1, but in 2000, the market returned 12.11%. We're talking about 12 month time horizons here, not daily or weekly fluctuations.
"Sure, if you need your capital back shortly after yields have risen, you do lose out a bit. But unless there is a rising inflation cycle leading to even higher interest rates, causing sustained lower returns for a while, you should get the higher running yield and ultimately better returns over time.
"Don't forget, like all markets, the fixed income market tries to be forward looking. The day you pick up the newspaper and read a headline like 'The RBA Raises Interest Rates' is probably not the time to get too negative on the outlook for fixed income market returns, because quite often the bulk of the negative impact on returns has already occurred.
"In a sharemarket example, buying a share at A$10 and seeing it fall to A$5 can and does happen. In fact, sharemarket corrections of 10% to 15% are reasonably commonplace. In fixed income markets however, there is no sensible scenario where this can happen2.
"Generally, investing is for the long term. Eventually, higher rates will lead to higher yields, making it less likely for a negative return to occur - let alone one of 5% or worse."
-ends-
1 As measured by the UBSA Composite Bond Index (0+)
2 These comments exclude a default on the part of the borrower(s).
For further information on this news release, please contact:
Lance Pupelis
Head of Income
Phone: (61 3) 9220 0363
Fax: (61 3) 9220 0333
Nick Tribe
Senior Fixed Income Manager
Phone: (61 3) 9220 0331
Fax: (61 3) 9220 0333
Bernadette Spiteri
Head of Retail Business
Phone: (61 3) 9220 0308
Mobile: 0408 162 515
Notes to editors:
Portfolio Partners is a Melbourne-based fund manager specialising in the active management of Australian assets. Our focus is on the asset classes we know best, where we believe we can add most value for our clients - Australian equities, fixed income and listed property. The considerable experience of our investment teams enables us to generate unique insights into the market and identify opportunities to further benefit our clients. Portfolio Partners is owned by one of the UK's largest funds management firms, Morley Funds Management, and is part of the international Aviva Group.