Should you ‘fire buy’ and forget your fixed income investments?
IN A LOW-INTEREST rate environment, alternative investments that offer higher rates of return, albeit higher risk, become more popular.
Thai mutual funds grow on average by 7 per cent in the past three years. The main growth contribution is from the spectacular expansion of Foreign Investment Funds (FIFs), ie mutual funds that invest in foreign assets. The size of these funds, now stands at Bt1.1 trillion, almost doubling the figure in 2009 and accounts more than 22 per cent of total Thai mutual funds.
Foreign investment funds can invest in wide variety of assets ranging from US treasuries, government bonds, mortgage-backed securities (MBS), corporate bonds, equity, properties, and commodities. Different mixes of assets experience different levels of risk and return.
For instance, if you invest in two global bond funds with different FX hedging strategies, risk and return are vastly different. During volatile FX environment, funds that actively manage FX risks could perform better. Evidently, according to AIMC five-year annualized return of Global bond fund without fully FX hedge yield from -1.95 per cent to 3.86 per cent with portfolio volatility from 2.4 per cent to 6 per cent.
However, if your Global bond fund is fully FX hedged, the return will increase to around 2.2 per cent to 4.0 per cent with narrower volatility about 3.1 per cent to 3.6 per cent.
What about the so called “relatively low-risk” investment funds which are typically labeled as “Fixed income” funds, the biggest components of the whole foreign investment funds (61 per cent of total FIFs net asset value). Could investors fire (buying orders) and forget their investments especially those “risk-free” government bonds? As a matter of fact, no! Investors should not be complacent as there is still “interest rate risk” which could spook you at night. Basically, an increase in market rates will lower values of fixed income assets. For example, if the assets in your portfolio are US fixed incomes, rises in Fed fund rate will inevitably lower their values.
So, how could investors estimate interest rate risk of their investments? Since it is getting clearer that the Fed will raise interest rate about 3 times this year according to their latest Dot Plot projection. Some Fed members and analysts even expect the numbers of rate hikes to be “4”.
Fixed-income investors could gauge the sensitivity of their portfolios’ values to changes in interest rate from “portfolios’ duration”. The concept about “duration” is quite simple. The longer the duration, the higher the sensitivity. Active fund managers can incorporate many strategies to minimise the impact from unavoidable interest rate risk. For example, fund managers may shorten their portfolios’ duration by buying shorter-maturity assets and short-selling ones with longer maturity.
Thus, as investors, we have to closely monitor how our invested funds manage the interest rate risk. For example, we can find duration of our funds from funds’ fact sheet. For foreign funds, they show effective duration, which is the duration of the fund’s portfolio, and benchmark duration indicating duration of bonds with similar characters to our funds. So, during a rising rate environment, if our fund’s duration is shorter than the benchmark, it can indicate that the fund managers are actively response to the changing environment. As a result, if the interest rate actually goes up, it is highly possible that the actively managed fund can outperform the benchmark.
Though, this information is not easily accessible for foreign investment funds and how information is displayed is not standardised and, sometimes, quite difficult to understand. Therefore, investment funds should provide not only insightful, but also easy-to-digest and up-to-date information about their products, while investors should actively search for information to gain deeper understanding about their investments. And most importantly, fixed-income investors just like other investors should take active interest in managing their portfolio so that their portfolios will not suffer from shifting interest rate regimes (both rising and falling).
Co-authored by DUANGRAT PRAJAKSILPTHAI and POON PANICHPIBOOL ([email protected]).
Views expressed in this article are those of the authors and not necessarily of TMB Bank or its executives.
