Normalization: The new buzzword in monetary policy

For the most part - recent ructions in select emerging market economies notwithstanding - global macro-economic conditions remain sound and arguably robust. The US economy continues to lead the way in developed market growth, having largely benefitted from the Trump administration’s ill-timed fiscal stimulus.

Recent economic data out of the Eurozone continue to best estimates, providing some evidence that the regional economic bloc is poised to emerge from their half-year funk. In Asia, US-China trade relations remain a key concern for the export-driven region.

Yet, uncertainty over trade policy has not entirely upended global trade flows and industrial production. Indeed, the region looks resilient enough to weather the storm of a stronger US Dollar, a slowing Chinese economy and uncertainties over trade policy.

Inflation on the rise in the US

In the US, inflation has picked up with the Fed’s target measure – the core Personal Consumption Expenditure Index – finally touching its 2% objective.

The Trump administration’s fiscal injection has triggered concerns of an overheating economy, pushing market-based measures of expected inflation higher as well. The US economy is already operating close to full-capacity and with the boost from higher oil and commodity prices, inflation is set to increase.

Yet, the current inflation environment remains controlled, with the risk of overheating largely contained, at least in the near term.

Slowly heading for the exit

Indeed, solid growth, tight labour markets and the recent uptick in inflation have triggered a shift in the monetary policy vernacular – from “policy easing” to “policy normalisation”. The interest rate cycle has already turned, with the US Federal Reserve leading the way on both counts of balance sheet and interest rate normalisation.

Other developed market central banks like the Bank of England and Bank of Canada have also pulled the trigger on interest rate increases this year. More central banks will likely follow. The era of low interest rates prompted by the 2007-2008 financial crisis is largely coming to a close. 

The Fed, ECB and BOJ: A review

The US central bank has delivered seven 25 basis points rate hikes since kick-starting the normalisation cycle in December 2015 and looks set to deliver more interest rate increases as their dual mandate of full employment and 2% inflation have largely been met. Proactive action is necessary to stave off further inflationary pressure, especially in view of the recent demand stimulus. Yet, the slow-moving nature of the inflationary threat provides scope to tighten policy at a gradual pace, much unlike previous tightening cycles.

Two quarter percentage point hikes are expected in the remainder of this year, while three to four more rate increases have been pencilled in for 2019.

Meanwhile, the Fed’s quantitative tightening programme which has been quietly operating in the background, is quickly accelerating. The programme will increase the drawdown of the Fed’s balance sheet to US$50 billion a month come October, from the current US$40 billion pace.

In the case of Europe, the European Central Bank (ECB) has already tapered asset purchases and is committed to ending its massive QE programme by December this year. Interest rate increases will probably follow, but perhaps at a much later date and at a rather glacial pace. Yet, the direction of policy is clear. The benign macro environment has weakened the argument for further policy accommodation.

Of course, policymakers are quick to note that they remain flexible in their decision making and could reverse course should circumstances change. Unless growth falls off a cliff due to escalating trade risks, we think the probability of the ECB pursuing further balance sheet expansion and/or pushing interest rates lower from current levels is relatively low.

The Bank of Japan (BOJ) is possibly last in line where policy normalisation is concerned as the central bank struggles to bring inflation up to its 2% target. The labour market is the tightest it has ever been in decades, yet wages have not seen much upward action. Consequently, inflation remains well below the central bank’s target. Hence, there is little impetus to begin the normalisation process.  
 
Interestingly, as can be gleaned from the chart below, the era of expanding central bank balance sheets is also nearing an end. While the Bank of Japan and the European Central Bank continue to expand their balance sheets as evidenced by the positive year-on-year change, the pace of growth has largely declined. Meanwhile, the Fed is already trimming its balance sheet, the pace of which is set to accelerate in October. Yes, the system is still flushed with easy money. But that too is nearing its peak.

Combined with the prospect of higher policy rates, monetary policy is poised to get tighter from here. The upshot is, interest rates, on both the short and long end of the yield curve, are set to increase. The direction is clear. The only questions are how fast and where will it stop.         

The case for floating rate notes

Given the monetary policy terrain, near term interest rate risks are by far the most pressing concern for bond investors. By one forecast, Bank of Singapore expects interest rates to move higher in the next few quarters, up till late 2019.

Generally, it is axiomatic that prices of fixed rate bonds tend to fall when short-term market interest rates rise, hence diminishing the value of an investor’s fixed income portfolio.

One solution to this problem would be to increase portfolio allocations to short duration fixed rate bonds. Typically, a bond's duration - or the number of years required for an investor to be repaid the bond’s price from the sum of all its coupon payments - determines how its price is affected by interest rate changes. As a general rule, for every 1% increase or decrease in interest rates, a bond's price will change approximately 1% in the opposite direction for every year of duration. As such, prices of short duration bonds tend to be less adversely impacted by interest rate increases relative to their long maturity counterparts.

Given these general dynamics, we recommend that investors target overall portfolio duration modestly below the market average of just under 5.0 years.

Another solution would be to increase allocation to Floating Rate Notes (FRNs) or bonds with coupon payments linked to some benchmark interest rate, such as the 3-month LIBOR. Unlike traditional bonds where periodic coupons are a fixed nominal amount, FRNs have variable coupons that adjusts periodically in line with changes to the levels of short-term benchmark market interest rates. Should short-term interest rates rise, FRN coupons will increase, thereby keeping bond prices stable and providing a cushion against higher interest rates.

Three key benefits

Floating rate notes offer three key benefits:

• First, cash flow – or coupon payments – tend to increase in a rising interest rate environment as coupon rates adjust upwards in response to higher interest rates. The alternative is also true, in that cash flows fall in a decreasing interest rate environment. As such, FRNs tend to perform better than their traditional counterpart in an economic environment where growth is solid, inflation is rising, and interest rates are increasing. A more robust growth environment tends to correlate with a period of higher cash flow generation, better corporate profitability and lower default rates. The current macro environment ticks all the boxes here.
• Second, because coupon rates adjust to market interest rates, floating rate bonds exhibit very low-price sensitivity to changes in interest rates. Put simply, FRNs have very low duration and are better able to mitigate interest rate risk.
• Third, prices of floating rate notes tend to be less volatile than prices of traditional fixed rate bonds. Essentially, the floating rate component of FRNs will absorb the impact of changing interest rates, hence keeping bond prices relatively stable across different market environments. This contrasts with fixed rate notes, where bond prices respond more elastically to interest rate changes.

Indeed, in view of the current rising interest rate environment and stable underlying macro conditions, increasing allocation to floating rate notes may be beneficial. In addition, floating rate notes can offer significant diversification benefits to fixed income portfolios with already large allocations into conventional fixed rate bonds.

However, buyers beware. While floating rate bonds help mitigate interest rate risk, investors will still be exposed to credit and liquidity risks when investing in this asset class – or any type of bond for that matter. As such robust credit selection is important to ensure that investors limit exposure to companies at risk of default or debt restructuring.

In addition, diversification across bond issuers, business sectors and geographical regions remain critically important to build a resilient portfolio and minimise single issuer risk.

The case for floating rate bond fund

Ultimately, investment managers with deep resources to conduct robust credit analysis, financial scale to access a large variety of issuers from numerous sectors and geographical regions that may not necessarily be accessible to the average retail investor, and a strong risk management framework can be particularly useful to manage investments in this asset class effectively.

In addition, with experienced portfolio managers at the helm, a focused fund may be better able to respond quickly to potential changes in market conditions. One should not underestimate the need for agile and expert stewardship during periods of heightened volatility when liquidity issues become acute. 

In all, floating rate bonds can help mitigate rising interest rate risks and offer significant diversification benefits to investors with huge exposure to traditional fixed rate bonds. Yet, interested clients should approach investments in this space in a diversified manner, that is through a unit trust that has a robust credit selection framework and a strict risk management process in place.

Admittedly, there is no such thing as a free lunch. Active management comes with additional costs in the form of annual fees and unit trust expenses. However, we believe this is a small price to better manage the risks inherent in this asset class. This is especially paramount in view of an investment terrain that is becoming increasingly turbulent.