How do fiscal and monetary policies impact the fixed interest asset class

To ensure an economy maintains sustainable growth, a government or Reserve Bank may take actions to influence macroeconomic conditions such as consumption, employment, inflation and liquidity.

In light of the pandemic, both the federal government and the Reserve Bank of Australia (RBA) introduced additional fiscal and monetary policies to stimulate the economy and minimise a potential recession.

It’s important for investors to understand monetary and fiscal policy, and the impacts they hold over the fixed interest asset class, as these can have a significant impact on an investment portfolio. 

What is the fixed interest asset class?

Firstly, it’s important to understand the fixed interest asset class. Fixed interest is considered a ‘defensive’ asset class where investors are paid a ‘fixed’ amount of interest or dividend payments until a pre-determined maturity date. At the maturity date, investors are repaid their initial investment. The most common types of fixed income investments are government and corporate bonds and are a common component in many investment portfolios.

What is the difference between monetary policy and fiscal policy?

In monetary policy, the RBA attempts to control money supply and influence economic conditions by adjusting the cash rate – that is, the overnight money market interest rate. Fiscal policy refers to the actions taken by a government to influence economic conditions by adjusting government spending and tax policies.

How does monetary policy impact the fixed interest asset class?

Many fixed interest debt instruments are aligned with the cash rate as a benchmark – typically paying interest as a specified percentage on top of the cash rate. When the cash rate is adjusted through monetary policy, the returns provided to the fixed income asset class are impacted directly. When the cash rate is increased, investors may receive higher fixed interest returns. Alternatively, when the cash rate is lowered, investors could also receive lower returns.

The fixed interest asset class is generally regarded as a stable capital asset class and doesn’t typically generate a large degree of capital growth. As a result, investors may rely on the direct income provided from their investment to support their lifestyle.

How does fiscal policy impact the fixed interest asset class?

Fiscal policy indirectly impacts the fixed interest asset class through consumer confidence.

When a government issues expansionary fiscal stimulus, they must first raise the necessary capital by issuing a fixed term debt to investors, reimbursed by fixed interest coupons. If potential investors lack confidence in the government’s ability to repay the bond, the government may need to incentivise by increasing the returns offered.

Governments that have a higher credit rating can raise money at a cheaper borrowing cost than those with a lower credit rating as the ratings agencies believe there is lower sovereign default risk associated with those governments with a higher credit rating. Australia is one such country with a AAA credit rating.

When choosing to invest in the fixed interest asset class and considering fiscal policy, investors must consider the type of debt and whether the returns on offer align with their appetite for risk.

Fixed interest has historically been regarded as a lower risk asset class. However, current market conditions and the lowering cash rate have diminished the returns on offer and created a  challenging environment for investors seeking to invest in the fixed interest asset class without proper active and risk management.

*Trilogy Funds offers professionally managed investment option to include fixed interest assets in your portfolio.

The Trilogy Enhanced Income Fund (the Fund) invests approximately 65% of funds are in cash, cash style assets and other financial assets, such as; a range of short to medium term bank deposits, bills of exchange, promissory notes, bonds, fixed or floating rate debt securities as well as income securities. The remainder is invested in the Trilogy Monthly Income Trust, a pooled mortgage trust that invests in loans secured by registered first mortgages over Australian property.

Investors in the Fund benefit from Trilogy Funds’ active management and prudent risk management, leveraging their experience to optimise the portfolio fixed interest allocation – so investors don’t have to.

Originally published here.