ICE Data Services Director, Business Development
ICE Data Services Associate Product Manager, Index & Analytics
It may be a new year, but inflation seems to be sticking around for a little longer and the problem doesn’t seem to recognize borders. The Eurozone saw prices rise by 5% last month — the highest for the bloc since the creation of the single currency, the U.K. saw consumer prices rise at their fastest annual pace in three decades, and the U.S. saw inflation hit 7%, a more than 40-year high.
Bond holders can be particularly sensitive to inflation and interest rate risk. Inflation has the potential to decrease the real return of a portfolio and may lead to higher interest rates as investors begin to demand greater compensation for a reduction in future purchasing power. Rising interest rates put pressure on the prices of fixed income instruments, which can further decrease total portfolio returns. Needless to say, the current environment is one that bond markets are likely paying close attention to.
Assuming elevated inflation persists, interest rate curves should continue to move too. A bond’s duration and its price sensitivity to interest rates, can be a key determinant of performance and fixed-rate coupons tend to have longer durations than floating-rates. To help understand how inflation could affect these different types of securities, we looked at the ICE BofA European Currency High Yield Index — which only contains fixed-rate securities — and the ICE BofA European Currency Floating Rate High Yield — which only contains floating-rate securities.
ICE Portfolio Analytics - Bonds allows users to create hypothetical scenarios to test how a portfolio of securities might react to parallel or non-parallel interest rate shocks. We used the two ICE indices as proxies for portfolios of fixed-rate and floating rate securities, respectively. The goal was to shock an entire portfolio, or in this case two indices, to quantify the impact at the extreme tail ends of different scenarios and at points in between. In our extreme scenario of a 300+/- basis point move in rates, the total return profiles were very different for the two indices. The fixed rate index exhibited superior upside total return performance when interest rates decreased, while the floating rate index offered downside protection when interest rates increased.
Total Return Index Scenario Analysis - Parallel Shift
Source: ICE Portfolio Analytics, Dec. 31, 2021
However, yield curve shocks don’t tend to shift in parallel. If the German sovereign yield curve “bear flattened,” which for illustrative purposes could mean the six-month rate increased by approximately 90 basis points, and the 30-year rate increased by 30 basis points, with progressive increases between, how would it affect the attribution across these securities? Using our ICE Portfolio Analytics data, over a 12-month horizon, the floating rate index outperformed the fixed rate index (3.841% versus 0.620%) on a total return basis. Because of its shorter duration and being less sensitive to rate changes, the floating rate index only experienced -0.211% of negative price return, while the fixed rate index lost -2.529%, which was attributable to price return but made up for it in the Income Return (3.149%) given higher coupons.
However, in a “Bear Steepening” environment, which for illustrative purposes could mean the six-month rate increased by 30 basis points and the 30-year rate increased by 90 basis points, the progressive increases between shows different results. The attribution showed that the floating rate still outperformed the fixed rate index (4.238% versus 0.949%) on a total return basis. The floating rate index experienced -0.113% of negative price return, while the fixed index lost -2.205%, meaning the fixed-rate index remained susceptible to price swings. Both indices had strong income returns, with the floating index returning 4.35% and the fixed-rate index returning 3.154%.
German Sovereign Bond Yield Curve
Source: ICE Bond Curves, Dec. 31, 2021
12-Month Projected Returns Attribution
Source: ICE Portfolio Analytics, Dec. 31, 2021
Understanding the relationship between how interest rates affect total portfolio returns can help investors and other market participants better manage risk and empower them to make more informed decisions when faced with external shocks. ICE’s tools provide users the ability to stress test their portfolios and help position themselves during periods of rising inflation.
ICE Portfolio Analytics - Bonds allows users to assess performance, risk and opportunity of an entire portfolio or at a single security level, with data, pricing and analytics across asset classes. The ICE ICE BofA European Currency High Yield and the ICE BofA European Currency Floating Rate High Yield are part of ICE’s global family of indices. ICE Data Indices, LLC (IDI) is a leading provider of indices across all major asset classes with more than 50 years of experience providing high quality solutions.