Active management will offer greater scope to add value to a fixed income portfolio as interest rates begin to rise, says research house Zenith.
In its 2017 Australian Fixed Income Sector Review, the researcher said inflation, or an expectation of inflation, has the “potential to erode domestic bond market returns” and that active strategies can protect against this.
A “common theme” to emerge from the review was that pro-cyclical fiscal policy put forward by the Republican party in the US is likely to increase inflation in the US, which is academically shown to influence other G7 countries – including Australia.
Zenith head of income and multi-asset research Andrew Yap said active management will be critical to preventing losses.
“While the RBA’s anchoring of inflation targeting to 2 per cent to 3 per cent has tempered potential absolute losses from a rise in inflation, in a low return environment minimising any loss is critical,” he said.
However, the impact rising rates will have on passive bond funds is unlikely to be problematic, according to Vanguard senior investment strategist Nathan Zahm.
“One of the important things to remember about bonds, and it’s the same in the equity market, is that bond pricing reflects everything that the market knows and believes about risk and the future,” he told InvestorDaily.
“A passive bond fund is really reflecting the market consensus, not only the risks in the market but also the expectations for future interest rates.”
By contrast, an actively managed bond fund will still need to take a non-consensus position to generate alpha, Mr Zahm said.
Rising interest rates could even prove to be a “significant positive” for longer term investors, Mr Zahm said, as higher rates typically mean higher yield expectations.
“It’s really important when looking at returns to look at the total returns, and so when rates do rise, if they do so unexpectedly, then there’s a capital loss on a bond in the near-term, but there’s also an increase in the yield,” he said.
“In actuality, rising rates – particularly for a pretty long-term investor – is actually a positive message because your expectations for future returns from bonds could be much higher if rates are higher than they are today.”
BlackRock head of iShares Australia Jon Howie also told InvestorDaily that rising rates will likely only prove problematic for short-term investors.
“As the Zenith report has highlighted, over the short-term you will often see a reduction in the capital value of a bond portfolio because of rising interest rates,” he said.
“When we look back at the last rate cycle in the US where interest rates went up between 2004 and 2006, while the price value of the overall bond benchmarks went down, the total return on those benchmarks actually was positive over that period.”
Additionally, the short-term drop in capital value will affect bond funds regardless of whether they are actively or passively managed, Mr Howie said.