Investing in and trading bonds can be profitable and improve the quality of your portfolio or chance of a capital gain. In this series, we explore some of the strategies used.

While there are many investment and trading strategies, you’ll need to take a view of where the economy (growth and inflation), interest rates and demand are headed. Often there are signals which can help. For example, the Bank Bill Swap Rate (BBSW) and the swap curve are an indication of market expectations of future interest rates. The RBA also publishes its expectations for GDP and growth in its economic outlook statements.

Whatever your views, we’d always recommend that you diversify your investments and in relation to the fixed income asset class investors should seek diversification by investing in:

• different types of bonds (fixed rate, floating rate and inflation linked)
• across various sectors (government, semi-government, corporate, financial institutions, insurance and infrastructure)
• across domestic and international issuers
• consider foreign currency bonds if you hold other currencies in your portfolio or have a future need for a specific currency

Diversification reduces risk and helps protect your portfolio, so that declines or losses in any one asset class, sector or issuer are minimised across your portfolio.

Different types of bonds have different roles to play under various economic cycles. When a cycle ends and another begins, it is worth assessing whether your bond portfolio has performed the role it was intended to perform. Near or at the high and low points of the economic cycle are the times to consider changing the emphasis of your portfolio but diversification remains key.

Economy starts to contract

Under a contracting economy, investors would have a preference for fixed rate, longer dated bonds. The aim would be to sell these bonds once you thought the economy had reached the low point to maximise your gain (remember the inverse relationship between price and yield). To make use of these strategies you need to take a view of the market.

1. 1. Risk off - Flight to quality

Under this strategy you anticipate a contracting economy and sell higher risk assets and buy low risk, high credit quality assets. Using the capital structure as a guide, you would sell off equities and hybrids, preferring senior secured and senior unsecured debt. Investors would prefer to invest in the lowest risk issuers such as the Australian Commonwealth government or semi-government or assets that sit higher in the capital structure such as covered bonds issued by the major Australian banks. During the GFC, investors seeking low risk high credit quality assets sought government bonds as a safe haven (see the case study below).

During an economic contraction, demand for low risk assets increases and this higher demand pushes the price of the bonds higher and the credit spreads lower. Investors are nervous about an increase in company defaults. As we know, investors that sit low in the capital structure take the brunt of a default, while the more senior debt holders are often protected.

CASE STUDY

In the 2011/12 financial year, the best performing asset class was Australian Commonwealth government bonds. Investors seeking a flight to quality and to preserve capital started buying these bonds. In particular, as the European financial crisis deepened, foreign investors sought refuge in AAA rated Commonwealth government bonds and highly rated semi-government bonds. The ACGL 15 July 2022 bond rose in price from $103.59 as at 1 July 2011 to $123.30 at 29 June 2012. The bond price reflected higher demand and the bond’s yield contracted (see Figure 1). Investors were more concerned about capital preservation than the low yield the bond provided, although the yield was comparatively high for a AAA rated sovereign at the time.

1. 1. Capital preservation

Capital preservation is similar to a flight to quality although this strategy aims to make sure that no capital is lost. Investors sell assets that sit low in the capital structure such as equities, hybrids and subordinated debt of high risk issuers and buy senior or senior secured bonds. An investor switching out of higher risk assets might target Government or semi-government bonds or government guaranteed bonds, although high quality corporate bonds that are short dated (thus increasing certainty about repayment) would also make good additions to this portfolio strategy.

1. 2. Buy fixed rate bonds and have a preference for them in your portfolio, sell floating rate notes

When an economy starts to contract the RBA will start to cut the cash rate to stimulate growth, which means investors, over time, will expect to earn less for their investments. Buying fixed rate bonds mean that as interest rates come down, the price of the bonds will rise (remember the inverse relationship between yield and price), offsetting losses in other parts of your portfolio such as property and equities. Fixed rate bonds will also protect your income stream. The coupon you earn on your floating rate notes will decline (as it is linked to a benchmark rate such as BBSW, which reflects the markets’ perception of interest rates) and as investors sell out of FRNs in preference for fixed rate securities, it’s likely that the price of the FRNs will also decline.

1. 3. Switch out of short dated fixed rate securities and into long dated fixed rate securities to increase duration and lock in known returns for longer

Locking in returns for longer makes sense when you’re unsure of how long a downturn will last. Think about the Japanese market which until recently had been in a low growth scenario for many years. The longer you can lock in that fixed rate return the better, not only in the sense of protecting the level of your income but longer duration investments will also have greater fixed rate bond price increases if you sell the bond after interest rates fall.

1. 4. Lock in longer dated term deposits

Just like fixed rate bonds, you would lock in longer term deposit rates. Westpac offered a high 8% fixed for five years at the start of the last contraction and those clients who accepted the long term commitment and could afford to lock away those funds made a good decision, when comparative rates for the same term at the end of 2012 were around 5.0%.

Next week Part 2 will consider investment and trading strategies for when the economy and the cash rate reach the low point in the cycle. For more information please call your local dealer.