Investment and trading strategies - Part 3

There are bonds that are suitable right throughout the investment cycle. While fixed rate bonds are preferable when an economy reaches the high point in the cycle and also when the RBA starts to cut interest rates, floating rate notes (FRNs) and inflation linked bonds (ILBs) are preferable when the economy reaches the low point and also when the RBA starts to increase the cash rate.

Diversification is the key to successful portfolio allocation. While your preference might be towards FRNs and ILBs in the current environment, if you are new to fixed income we would suggest you include all three main types of bonds in your portfolio. That way if the economy takes an unexpected turn for the worse, it will be in part protected by an allocation to fixed rate bonds.

Please click here to read Investment and trading strategies Part 1 “When an economy starts to contract” and here for Part 2 “The economy and the cash rate reach the low point in the cycle”.

Economy is growing and the RBA is increasing the cash rate to limit growth

During this phase the RBA will be increasing the cash rate (this is known as tightening) to try and constrain growth. Growth and inflation are typically correlated. So, during this phase of the cycle, investors can expect rising inflation, best hedged through an allocation to inflation linked bonds.

1.1. Have a preference for FRNs and ILBs

FRNs and ILBs will reflect changes to growth expectations through their coupons. The FRN coupons are tied to the Bank Bill Swap Rate (BBSW) and the ILBs are tied to the Consumer Price Index (CPI). Both of these bonds make quarterly interest payments. Fixed rate bonds will be less attractive under this scenario and bond prices should decline. Sell fixed in preference for FRNs and ILBs. Continue to hold some fixed rate bonds as downside protection.

1.2. Decrease duration

Sell long dated fixed rate bonds for shorter dated fixed to reduce exposure to interest rates. A portfolio with a longer duration will be more susceptible to losses from higher interest rates.

1.3. Keep term deposit investments short

Depending on how aggressive the RBA is tightening by increasing interest rates, keep term deposit maturities short. Remember the RBA meet monthly to determine rate changes. A very aggressive tightening may mean the best option is a 30 day term deposit or an at call account where interest rates can be more reflective of the environment. Newer style floating rate term deposits may be suitable but check the terms for recalculating the interest rate.

1.4 Sell fixed rate government bonds and buy inflation linked government bonds

Most government bonds are fixed, so under this scenario their prices should decline. Governments issue inflation-linked bonds, so if you have a preference for very low risk government bonds buy ILBs instead of the fixed rate bonds on issue.

1.5 Risk on

Have a preference for higher risk issuer’s bonds and securities over low risk issuer’s securities. Companies are less likely to default when the economy is growing.

Next week Part 4 will consider investment and trading strategies for when the economy and the cash rate reach the high point in the cycle. For more information please call your local dealer.