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Disruption, inflation and what they mean for fixed interest

Disruption, inflation and what they mean for fixed interest

— 1 minute read

Disruption means different things to different people. For many, examples such as Uber, AirBnB and driverless cars come to mind.

Jay Sivapalan

For fixed interest investors, the impact that disruption has on prices is key, namely whether it is inflationary or disinflationary.

Inflation is one main indicator that determines whether central banks raise or cut interest rates. Official cash rates and cash rate expectations influence the direction of bond yields, which in turn has an inverse relationship with bond returns. Rising bond yields are not typically good for fixed interest returns.

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A relevant example of disruption for fixed interest investors over the past few decades has been China’s entry into global trade. The production of consumer goods by the world’s largest factory (China), exporting to the world’s largest consumer (US) has led to 30 years of generally falling consumer goods prices.

These disinflationary influences, in part, have led to lower interest rates, lower bond yields and conversely stronger returns for fixed interest investors. It has been a 35+ year ‘bull market’ for global bonds.

Other sources of disruption that can lead to low inflation are:

  • Technological advancements typically leading to lower prices for consumers.
  • Competition, such as online shopping, where new competition and greater price transparency are leading to lower consumer prices.

But not all disruption brings lower inflation:

  • Political disruption, as experienced by the recent trade wars and anti-globalisation movement, can result in trade barriers such as tariffs, which may lead to higher consumer prices in due course.
  • Adverse weather conditions can have an inflationary impact, including higher insurance premiums and short term spikes in food prices.

Managing the downside risk

With interest rates and bond yields near historical lows, fixed interest investors’ returns are susceptible to a rise in the cash rate, inflation expectations and/or rising bond yields. For example, markets are currently expecting the Reserve Bank of Australia (RBA) to cut the cash rate twice by December 2019 and for inflation to remain at no more than 1.4 per cent over the next decade. This is a very pessimistic view of Australia’s economic outlook, and should the market become even slightly more constructive, expectations for cash rates and inflation will rise. In this context interest rate risk is the most important risk to monitor and manage – our focus is on managing the downside risk for fixed interest investors.

Harnessing income in a low yield environment

In what still remains a low-yield environment for fixed interest investors, exposure to high quality corporate debt remains a valuable source of enhancing income for investors.

Australian fixed interest investors can gain exposure to high quality corporate debt from global and Australian companies like Apple, Toyota and Wesfarmers in their portfolios. While not being risk-free, these corporate bond yields should comfortably exceed the returns of risk-free assets such as Australian government bonds of the same term to maturity.

Investors can also access senior debt of core infrastructure companies, such as Port of Melbourne. Core infrastructure companies are less likely to be impacted by economic recessions, providing good levels of income without taking on high levels of risk.

Capital preservation in challenging times

In the fourth quarter of 2018, the Australian equity market sold-off while fixed interest generated positive returns. Over the 2018 calendar year, Australian fixed interest returned 4.54 per cent, while Australian equities returned -2.84 per cent. This clearly demonstrates the defensive characteristics of fixed interest (often described as ‘portfolio insurance’) during equity market stress and the benefits of holding a diversified portfolio of investments across a range of asset classes.

Active management of interest rate risk, combined with a vigilant approach to security selection, can create diversified investment portfolios with underlying investments that aim to preserve capital in adverse financial market conditions.

Jay Sivapalan, co-Head of Australian Fixed Interest, Janus Henderson

 

Disruption, inflation and what they mean for fixed interest
Jay Sivapalan
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