Floating-rate credit offers value

09-Feb-2017

By Sarah Kendell

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Floating-rate bonds currently presented the strongest opportunity for fixed income investors as they were relatively cheap to hold, offered solid returns and were not at risk from rising interest rates, according to Perpetual.

Speaking to financialobserver, Perpetual head of fixed income Vivek Prabhu said while the defensive characteristics of many bonds were diminishing with interest rates at record lows, allocating to floating-rate credit could generate strong returns while also presenting better value than yield proxy stocks such as infrastructure companies or real estate investment trusts.

“I think a lot of fixed-rate portfolios that are based around a composite bond benchmark have been increasing in terms of the underlying risks precisely at the time where the compensation for that risk is at record lows – a few years ago the index interest rate duration was two years and today it’s closer to five,” Prabhu said.

“In response to that we developed a dynamic fixed income fund built around the level of interest rate duration you need to take to optimise risk and return – it’s dynamic because it can change its duration rate from zero up to four years, so we can capture the term premium of the credit spread and not introduce excessive amounts of volatility, but still provide that cash plus return.”

He said the time was right for advisers to consider active fixed income funds for their clients, given term deposits now offered less liquidity and reduced yields, while hybrid securities also presented increased risk for little payoff.

“Hybrids have been popular because they’ve got a high yield, there is no minimum parcel size because you can access them through the ASX, and whilst that has been a successful strategy for a while, now there are embedded risks that people need to be aware of,” he said.

“Traditionally they were a combination of debt and equity, but with the new banking regulations a lot of bank hybrids have become even riskier than the old generation of bank hybrids – their characteristics are much more equity like and the compensation hasn’t gone up, so you are taking almost equity-like risk without the true upside of equity.”

Floating-rate fixed income funds were also a good option in light of the current market outlook, with rising United States interest rates expected to change the dynamics in the bond market over the course of 2017, he added.

“With floating-rate funds you can benefit in a rising rate environment because they have very little sensitivity to interest rates – the coupons reset either monthly or quarterly, so a rise in interest rates will be reflected in a rise in the income generated from these securities,” he said.

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