Inflation pressures could lead to rates moving higher sooner than central banks are signalling.
Floating Rate Notes (FRN’s) with their interest rate reset feature are less sensitive to rising rates than traditional bonds.
The fundamental outlook for FRN’s appears attractive given the anticipated acceleration in growth as economies reopen globally.
With the low level of bond yields, many investors are reassessing the role of bonds as the evolving macroenvironment unfolds. A key risk is that interest rates and bond yields rise in response to evolving growth or a change in policy.
Inflation is also a key concern and is one of the driving factors behind investors’ worries. In her piece, Putting the Global Inflation Surge in Perspective, Simona Mocuta, Senior Economist at State Street Global Advisors highlights five possibilities that could be considered as highly influential drivers of inflation, the most immediate being supply chains/peak globalization. Low base effects from a year ago, supply chain bottlenecks, and persistently underestimating demand during the Covid-19 recovery have resulted in big increases in inflation data. Rising inflation could lead to higher interest rates. This would likely put downward pressure on growth stocks and fixed income investments.
As growth accelerates amid the reopening, policymakers will likely begin tapering bond purchases, already indicated in the latest US Federal Reserve System minutes, although the timing of such tapering is still being debated, it should then see bond yields move higher. Fuelled by expectations for higher growth and inflation, Bloomberg forecasts1 estimate the US 10-Year Yield to reach 1.64% by the end of the year and 1.83% by Q2 2022. Domestically, the Australian 10-Year Yield is forecast to reach 1.56% by the end of the year and 1.79% by Q2 2022. For fixed-rated bond investments, prices and yields move in opposite directions. With yields anticipated to rise, investors should be cautious around how much duration exposure they take. Duration induced price declines for traditional fixed income assets could present significant headwinds. Investors who prioritise the diversification benefit and liquidity of sovereign bonds may consider lowering the duration of their portfolio to mitigate the risk of rising rates.
One segment of the fixed income market that investors can consider is FRN’s. FRN’s with their interest rate reset feature are less sensitive to rising rates than traditional bonds. The average duration for floating rate notes is typically near zero. Given this, they can help to protect a portfolio when interest rates are rising. In fact, due to these structural traits, over the last two years, the Bloomberg Ausbond FRN 0+ Yr Index has outperformed the broader Bloomberg AusBond Composite 0+ Yr Index for half of the time, that is for 12 out of the last 24 months2 as can be seen in figure 1 below. By mitigating losses through periods where the composite index was negative, the FRN index is actually (marginally) outperforming over the two year period.
Figure 1: Bloomberg Ausbond FRN 0+ Yr Index vs Bloomberg AusBond Composite 0+ Yr Index
And while outperforming, they have also done so with significantly less volatility. The chart below highlights that FRN’s provided much higher yields per unit of risk than a range of other fixed income sectors.
Figure 2: FRN’s offer better yield per unit of risk compared to other bond market segments
So far this year, the Bloomberg AusBond Credit FRN 0+ Yr Index is up 0.46%3 versus the Bloomberg AusBond Composite 0+ Yr Index which is only up 0.08%4 and which has also experienced a 4%5 drawdown this year, further highlighting their attractiveness as market risk increases.
The fundamental outlook for FRN’s appears attractive given the anticipated acceleration in growth as economies reopen globally. Despite below average yields, FRN’s still remain relatively attractive compared with other fixed income segments. While sharply rising inflation may pose challenges, an allocation to FRN’s could potentially benefit investors seeking a fixed income option with less sensitivity to rising interest rates.
1 Source: Bloomberg Bond Yield Forecasts (“BYFC”) as of 1 September 2021 2 Source: Bloomberg Finance L.P., as of 31 August 2021 3 Source: Bloomberg Finance L.P., as of 31 August 2021 4 Source: Bloomberg Finance L.P., as of 31 August 2021 5 Source: Bloomberg Finance L.P., as of 31 August 2021
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