AMY XIE PATRICK: How to manage fixed income portfolios in this environment

As investors prepare for lower rates, our head of income strategies AMY XIE PATRICK sat down with portfolio specialist DALE PEREIRA to answer some common client questions

DALE PEREIRA (Pendal’s head of client solutions): As economic growth slows and inflation comes under control, markets are expecting interest rates to fall in the US and Australia this year.

How are you managing fixed income portfolios in this environment?

AMY XIE PATRICK (Pendal’s head of income strategies): “We manage our portfolios to a simple philosophy when it comes to the interest rate cycle.

“When the RBA is hiking interest rates, we like to take our credit exposures in floating-rate form.

“This means the income returns of the portfolio will be able to keep up with the rising interest rate environment.

“But when the RBA is cutting interest rates, we like to switch our exposures to fixed rate. This locks in a higher level of income, even as interest rates fall to much lower levels.

“It’s the same as a homeowner taking out a mortgage, only in reverse.

“When you think the RBA is going to cut interest rates, you want your mortgage rate to be variable so those rates fall as the RBA slashes rates.

“When you think the RBA is going to raise rates, you fix the rate on your mortgage at low levels.

“We do the same thing for Pendal Monthly Income Fund portfolio – but we want as high a yield as possible.”

Dale: Are you fixing the rate of your credit portfolio now?

Amy: “We’re not rushing to do it just yet.

“Bond yields do look really attractive compared to the last decade. But when you take a longer-term perspective, these are just more normal levels of interest rates.

“The RBA is also not entirely convinced that it’s won the inflation battle, especially with strong immigration flows still pushing up demand in our economy.

“So we’ve been dipping our toes in, but we’re not yet ready to fix the whole portfolio.

“By doing it in slices, it maintains flexibility in our portfolio as well as protection in case bonds have another sharp sell-off like they did last October.

Dale: What signals indicate it’s time to turn your income portfolio towards fixed-rate assets rather than floating-rate bonds?

Amy: “Wages matter to the RBA almost more than any other central bank.

“I’d want to see wage inflation in Australia roll over and head convincingly down to that 3.5% type of level where the RBA feels is consistent with their 2% to 3% inflation target.

“Our proprietary wage indicators at Pendal have stopped rising, but they appear a bit sticky at just over 4%.

“That doesn’t mean there won’t be opportunities along the way in rates.

“We will seize these opportunities with our active interest rate process just like we did during the regional banking crisis in the US last year and during the fourth quarter of 2023.”

Dale: Most of us think of fixed income as a defensive asset class. When equities are strong and the market isn’t worried – and isn’t looking for protection – why bother with bonds?

Amy: “My career in markets has taught me that bonds will do their own thing.

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“There is no hard rule that says bonds have to go up when equities go down.

“The main things that drive bond performance are growth and inflation. The macro fundamentals are usually what matters to bond market direction.

“For example, in 2022 bonds didn’t work to protect against falling equities because inflation was a far bigger problem than slowing growth.

“Today growth is still not a problem, but inflation is coming down all over the world. The shocks from the pandemic are finally working their way out of the system.

“If the downward inflation trend continues, bonds can still do well regardless of whether the economy slows from here.

“Look at 2023, Australia grew more than 2% and yet Aussie government bonds returned more than 5%.

“The US economy grew at over 3% and global bonds returned close to 6%.

“Those data points tells us you don’t need to be bearish on the economy in order to be bullish about bonds in your portfolio. “

“While cutting cycles are great for bonds, actually the best time for bond returns is simply when the hiking cycle stops.

“Bonds tend to outperform equities in this part of the cycle.

“That means you’re coming into the best period for bond returns right now. And wouldn’t it be a shame to say no to bonds and miss out on all this opportunity?”

Dale: Why would you invest in a bond portfolio rather than a term deposit?

Amy: “For some investors, term-deposit returns on cash are enough – they’re more than happy to take those returns after years of really slim pickings in this area.

“But for most investors who chose term deposits over fixed income last year, their biggest frustration was missing out on the upside.

“Both bonds and equities outperformed term deposits in 2023.

“This year, locking in 5% term deposits might sound nice at first.

But you would also be locking up your capital for a year.

“It makes it harder to move your money around when things change, which means you can’t deploy it quickly or easily to buy the dip if we get a decent correction in markets.”

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Pendal’s Income and Fixed Interest funds

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