In our previous update we touched on some core principles of fixed income investing. The key principle covered was the concept of interest rate risk. Interest rate risk refers to the risk that value of your fixed income investment will change when interest rates change. This is important for investors to understand because the value of their fixed income investment can fall when interest rates rise. Bonds which pay fixed coupons and have longer maturity dates carry the most interest rate risk. In this update we will introduce “default risk”, discuss the different types of bonds and how to manage these risks in a portfolio.
The most straightforward way minimise interest rate risk is to invest in floating rate bonds. Floating rate bonds are less sensitive to changes in interest rates. The problem with this strategy is that many issuers of floating rate bonds carry a higher probability of default. Default risk refers to the risk that you may not receive some or all of your investment back at maturity. The bonds with the lowest default risk are long term fixed rate bonds issued by the largest global governments. On this basis, in order minimise default risk investors must accept some interest rate risk. The table below summarises the different types of bonds and associated risks.
Source: Schroder Investment Management
Another problem with floating rate bonds in the current environment is that the return on offer does not reflect the associated risks. Low interest rates around the world have forced investors to look elsewhere for income generating investments. This has caused many investors to purchase higher risk bonds because of the attractive income on offer. Investors have purchased these higher risk bonds to the point where the yield on offer does not satisfactorily compensate a new investor for the risk. Higher risk bonds also have lower liquidity. Liquidity is the ability to sell or buy or bond in the market when required.
In conclusion, we want to avoid higher risk bonds because the yield on offer does not adequately compensate an investor for the risk of default. This leaves our portfolio largely focused on government bonds, semi-government bonds, high quality corporates and cash like investments. The portfolio will remain exposed to interest rate risk because most of these investments are more sensitive to changes in interest rates.
This risk is greater when interest rates increase because the price of a bond will fall. This risk is mitigated in the current environment given an unexpected increase in interest rates is unlikely due to the slowing global economy. This was confirmed at the last meeting of the US Federal Reserve where the US opted not to increase interest rates, whilst in Australian the RBA is considering reducing interest rates again.
The next edition of Fixed Income Focus will be the final in the current series. We will bring the previous discussions together to summarise our current investment strategy and how we are implementing it through our preferred investment managers.