With Australian core inflation spiking in December, it is essential to consider the impact of inflation on asset allocation. Persistent high inflation has several implications for credit markets, which we believe need to be managed via both fixed and floating rate strategies. There are also a few options for investors looking to mitigate the impact of inflation on the defensive allocation of their portfolios as Michael Korber, Managing Director Credit & Fixed Income, explains.

With US CPI at 30-year highs and Australian core inflation spiking in December, it is essential to consider the impact of inflation on asset allocation. Specifically, it is crucial to understand the differences in how floating and fixed rate credit and bond investments are expected to perform in an inflationary context.

The impact of inflation on fixed income and credit portfolios is most keenly felt through the policy response of central banks – most notably the US Federal Reserve (The Fed) and Reserve Bank of Australia (The RBA). Central banks have recently accelerated the tapering of Quantitative Easing and (in the case of the BOE, BOC and RBNZ) begun to increase policy rates. Markets have priced in a rapid increase in the Fed funds target rate and the RBA cash rate commencing as early as March. The increased yield volatility observed over the last quarter of 2021 and into early 2022 has been a salutary reminder of the sensitivity of financial markets to the shifts in central bank policy.

Throughout the tightening cycle, the increases to policy rates see bond yields rise, causing capital losses for traditional bond funds. Over the past year, the Bloomberg Ausbond composite index has lost 2.87% as the Australian 10-year yield has risen 80bps. With persistently high inflation print putting pressure on central banks to accelerate their tightening cycle, we expect to see further interest rate volatility throughout 2022.

While typical bond funds are adversely exposed to increases in interest rates, floating rate funds will benefit from increased coupons. Floating rate bonds pay a variable interest rate expressed as the Bank Bill Swap Rate plus a fixed premium. Shifts in bond yields do not impact the valuation of the floating rate bond but rather the income generated. Thus, in a context of rising interest rates, fixed rate securities experience capital losses while the income generated by floating rate securities increases. Floating rate strategies can be built by investing in floating rate securities exclusively or by investing in fixed rate securities and hedging the interest rate risk via short treasury futures or interest rate swaps.

 

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There are a number of strategies to mitigate the impact of inflation on the defensive allocation of your portfolio.

  • Floating rate credit funds offer an attractive yield and smooth return profile without exposure to interest rate risk.
  • Benchmark unaware fixed income funds with either conservative strategic duration or the ability to tactically reduce interest rate sensitivity, also offer robust running yield while minimizing the downside risk of the RBA’s tightening cycle.

There are further implications of persistent high inflation for credit markets which need to be managed across fixed and floating rate strategies. Crucially, high inflation puts strain on margins and can contribute to weaker earnings at this stage in the cycle. Also, collateral where valuation is impacted by yields (such as direct property) may be adversely impacted by rising interest rates. Credit quality depends on robust earnings which can be negatively impacted by inflation. Perpetual’s quality filter focuses on companies with credit worthy fundamentals that will be more resilient to shrinking margins and cost pressures in an inflationary environment.

Furthermore, the team’s credit research system emphasises credit quality as crucial input. While valuation supply and demand and technical indicators have cooled, credit quality remains robust. Economic and earnings growth over the last 18 months has facilitated a very strong ratio of upgrades to downgrades across US Investment Grade and High Yield alongside Australian Investment Grade credit which continues to be very supportive for the outlook. We believe that active floating rate credit strategies with a focus on quality issuers offering a competitive yield present an excellent alternative to traditional bond funds when inflation is high and central banks are tightening policy.

Originally published by Michael Korber, Managing Director, Credit & Fixed Income, Perpetual