Fixed income products - the volatility survival kit
As we enter into a rising interest rate cycle amid highly volatile markets, moving clients’ money into fixed income products can offer significant protection to their portfolios.
Fixed income is often seen as an investment opportunity when people find they have lost money or are experiencing low returns from riskier asset classes. Only then do investors start to consider taking defensive positions in their portfolios.
Taking a defensive position
Funds with exposure to fixed income instruments provide the opportunity to position a portion of a client’s portfolio defensively.
Fixed income products such as bonds represent an agreement between investors and institutions or companies to pay holders a specific rate of interest for a fixed duration, and redeem the contract at face value on maturity.
When we speak of a coupon, we are referring to the interest paid on a bond through to maturity. While the coupon of fixed income instruments does not change, price and yield do, depending on market conditions such as inflation and interest rate cycles. Rising interest rates adversely affect the market price of fixed income products.
Some Income Funds are giving an average annualised yield of 8%, which is attractive to conservative investors and those looking to beat inflation and ensure the value of their capital is not eroded in a volatile market.
Fixed income and interest rate cycles
We believe we are at the bottom of the interest rate cycle globally, and have therefore defensively positioned our funds into floating rate notes. This means the fund is able to achieve high yields with very similar capital risk to that of money market funds.
Floating rate notes are instruments issued with a certain maturity and at an interest rate over a certain benchmark, for example, Johannesburg Interbank Agreed Rate (JIBAR) plus 200 basis points. The JIBAR rate is the average interest rate at which banks will issue money market instruments to the market.
These notes are more sought after in rising interest rate environments, as they reset with interest rate changes.
The other side of the coin
On the other hand, fixed rate instruments repay capital at the end of a contract and have a predetermined coupon - if you buy at a 10% coupon, you will receive 10% every year even if interest rates rise. This means any long maturity of repayment of capital has increased sensitivity to interest rate changes and inflationary pressures.
The more adventurous investor could consider a Bond Index (ALBI) Fund, which allows for access to fixed income instruments through a unit trust fund that provides investors with a low cost exposure to bonds.
While it is not typical to invest in bonds at the bottom of an interest rate cycle, it could be considered a long-term defensive strategy, and as inflation policy pans out and interest rates rise, further opportunities in bonds will become apparent.
Investors who are already invested in a bond fund should probably not disinvest.
The 9% marker
However, investors who plan to increase their exposure to fixed interest assets could consider investing in a Bond Fund when the R186 bond trades above 9%.
Government finances drive bond prices due to their substantial influence on supply and demand of fixed income instruments. As South Africa’s twin deficit has grown, there has been waning foreign interest in domestic bonds. This decreased demand means rates go up and the market prices of the underlying instruments decrease.
Considering the weak state of the domestic economy, more conservative investments are desirable, as a high interest rate environment is typically not good for more risky asset classes such as equities and property.
Now could be considered a good time to adopt a defensive interest rate strategy for your clients and invest in an Income Fund.
