Navigating Bond Volatility

Navigating Bond Volatility

Navigating Fixed Income Volatility: Strategies to benefit from rising interest rates

September 25, 2015. by PM

The market environment for income investing has been fraught with challenges in recent times. Until recent months, extremely low yields for bond investors made unearthing attractive income and potential return opportunities in fixed income hard to come by. However, having witnessed a post COVID recovery, support by massive government spending programs and easy monetary conditions on the part of central banks, the economic recovery and attendant inflation that is fueling bond market fears, rather than alleviating investor’s concerns. However, for income investors there is a silver lining – a much wider array of asset classes offering attractive yields.


Opportunities to benefit from inflation and rising rates

Policy makers are rising to the enduring inflationary pressures by increasing interest rates. More traditional fixed income approaches will often be under pressure during such periods of policy tightening, although there are strategies available which are able to generate income and weather the inflationary storm. A flexible, dynamic approach which has the flexibility to gain exposure to a number of asset classes in the fixed income space can do just that. Rising income levels from across a number of asset classes


Past performance does not guarantee future results.


REIT preferred yield as of February 28, 2022; all other yields as of March 31, 2022


Source: ARIA,Bloomberg, FTSE Russell, JPMorgan Chase, MSCI and AllianceBernstein (AB)


In an era of historically depressed interest rates, generating attractive income streams has meant taking on greater levels of risk than many investors may have been comfortable doing. In fact, traditional fixed income investors have often been pushed into equities to pick up sufficient yield. However, with inflationary pressures rising, geopolitical tensions and central banks raising base rates, the options are somewhat wider now.

To give an example, as can be seen from the above chart, emerging market debt now pays nearly 6.4%, which is comparable to its best yield at any point during the last 10 years. That’s not to say that we would recommend income investors should be simply plump for the highest yields – such a decision needs to considered in light of the risk of that particular asset class. However, fixed income asset classes generally across the board are offering much more attractive yields – high yield credit and global investment grade bonds are up to a solid 6% and 4% respectively, compared to 4% and 2% at the turn of the year. Investors who can retain a high degree of selectivity, emphasing those opportunity backed by fundamentally strong companies, do often mean a much more compelling risk to reward proposition.


Fleet of Foot

With the global economies plied with huge fiscal stimulus and money printing, which is now being put into reverse, its important to remain nimble footed – that means staying active. It can be tempting to adopt a passive approach to fixed income – passive approaches mean buying and holding investments, with a view to riding through any turbulence. During decades of falling interest rates such an approach has, except for periods of episodic volatility or events, generally worked. But remaining on autopilot in today’s investing environment may mean not just being vulnerable to rising inflation risks and interest rates, but missing out on some of the opportunities increased volatility can bring. In contact, active management means using all the options in the options box, to navigate market turbulence.


Where to Invest

There are a number of strategies within income producing assets that can seek to benefit from rising interest rates.


Reducing interest rate sensitivity

During times of rising interest rates, it can be sensible to reduce duration. Duration measures the sensitivity of an investment’s price to changes in interest rates. It is possible to buy short duration corporate bonds for example, that fluctuate less in response to varying interest rates, than longer duration bonds do. A shorter duration bond may have a term to maturity of 2 years, as opposed to longer durations being 10 years.


Inflation protection strategies:

Active managers have the ability to buy inflation linked bonds – fixed income holdings whose coupon ratches up in line with a given reference inflation rate, meaning income streams move up in lock step with rising prices.


Real Estate Investment Trusts (REITs)

Property historically has been a good hedge inflation – its value has increased as prices rise. Real estate investment trusts can invest across different geographies and different property types – be that residential, commercial or even as targeted as ‘data centres’ or hospitals. Given that the underlying tenants pay rent, REITs can pay attractive income levels, whilst also increasing in value.


Interest Rate Hedges:

A fund that offers access to a breadth of income producing assets, but also has the ability to neutralise or reduce the impact of interest rates, yet preserve income flows are potentially good options in this environment.

The key is to remain flexible and diversify across a number of income generating assets in building an investment with an attractive yield and appropriate risk profile. Strategies such as corporate bonds, senior secured loans, real estate investment trusts all complement each other to provide income that can increase as interest rates do, whilst holding its own as inflationary pressures bite.


The Importance of Income in Total Return

There’s no shortage of research to demonstrate how long-run returns are influenced by the reinvestment of dividends – even in equity markets. This is because the reinvestment of modest dividend amounts can soon grow to become a dominant part of the total return. Indeed, those stocks that are able to offer a consistent and rising level of dividend tend to strongly outperform during periods of flat stock market performance, as a result of investor demand for income particularly when interest rates globally are at historically low levels. The following chart breaks down total return into price appreciation and dividends for US equity returns, and shows the importance of income over the long run. Dividends matter.


Proportion of S&P500 total returns due to price and dividends analyzed over different moving average periods, i.e. the average over a given period of time, from December 31,1940 to December 37, 2011.

Source: ARIA, Bloomberg, Guinness Atkinson


How to Invest:

ARIA offers it’s Alternative Income Fund – a multi asset and multi strategy fixed income Fund, that gains access to a range of income asset classes. Moreover, it is characterised by a very active approach, demonstrated in recent times how it has preserved capital during a period when many fixed income funds have fallen.

For more information, please contact your financial adviser or local ARIA office.


Rising rates benefit investors in the long run

Generally rising interest rates occurs during periods of economic recovery, and in that respect asset prices on balance do well. Increasing interest rates also mean investors can benefit from higher yields, which can either provide a meaningful income stream or increase the total returns achieved over time as that income can be reinvested.

Unprecedented actions by central banks globally had suppressed interest rates and therefore income streams for investors. As key economic metrics improve, and in some cases overheat (such as inflation), policy makers are now being forced to raise interest rates at swift clip. Inevitably, this will mean higher volatility in income generating assets than witnessed in recent times, but for nimble footed, active investors, it is creating an opportunity to generate attractive yields once more.

Information is based on our current understanding of taxation legislation and regulations. Any levels and bases of, and reliefs from, taxation are subject to change. Tax treatment is based on individual circumstances and may be subject to change in the future. Although endeavours have been made to provide accurate and timely information, we cannot guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No individual or company should act upon such information without receiving appropriate professional advice after a thorough review of their particular situation. We cannot accept responsibility for any loss as a result of acts or omissions.

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