At a time when duration is front of mind among fixed income investors, many could be overstating the probability the asset class is heading for outright negative returns, says Simon Warner, AMP Capital’s Head of Fixed Income.
Late in the investment cycle, as Central Banks move to tighten interest rates and inflation looms on the horizon, there’s never been a more critical time for fixed income investors to be thinking about the duration they own, Warner notes.
However, some of the positives associated with holding duration as a defence to offset more aggressive parts of an investment portfolio could be getting lost amid concerns about the risks, Warner reckons.
There’s currently no pressure on the Reserve Bank of Australia to raise rates aggressively and there’s very little inflationary pressure here despite moves by the Federal Reserve in the United States to raise rates, Warner notes.
“Although the US Fed will be raising rates, the RBA will continue to lag,” Warner says during an interview with AMP Capital TV, highlighting that investors in the local fixed income market might be overstating the risks of holding duration.
Warner’s team will be presenting research at the upcoming Fixed Income Forum assessing the outcome of negative outright return in the Australian fixed income market to be quite low.
Indeed, a lot of people are worried about rising interest rates and what that means for the value of their bond portfolios, assuming that interest rates are about to spike and inflation is about to emerge and that it’s a really dangerous time to own duration in fixed income, Warner outlines.
“At this stage of the cycle, duration is a hot topic and it’s something we talk to consultants and customers about all the time,” Warner says.
Holding duration at the end of an investment cycle can defend against the more aggressive parts of your portfolio, a characteristic that is sometimes forgotten in the conversation about risk, he notes.
Through the cycles
Clearly, we’re well into the latter stages of the investment cycle, Warner explains.
Phase one of the cycle is the recovery phase, where interest rates are kept very low and there’s an acceleration in economic activity.
Second phase is where everything is pretty stable, where there’s no pressure on interest rates to go up because inflation hasn’t emerged and growth is very solid.
The latter phase is when there’s more pressure on interest rates to go up and investors need to be more mindful of when the cycle might eventually end, Warner outlines.
Credit has different appeal and displays different characteristics during each of these phases, Warner says.
In the first phase, when credit spreads are quite wide because in the aftermath of a recession there are more defaults, investors can expect to “ride credit spreads in”, getting reasonable capital gains from spread compression.
In the middle phase of the cycle credit spreads aren’t very high but they still compensate you for default; at this point in the cycle you’re going to get low defaults because the economy is very strong.
“In the latter phase of the cycle you want to be careful about which names you’re exposed to and how much aggregate credit risk you have because the backward looking default experience is not going to be a good reflection of what real default risk will be looking forward,” Warner says.
“It's at this [latter] stage you need to be looking forward because you need to be thinking about the end of the cycle,” he adds.
While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.