Taking the high (income) road as rates fall

Following its most aggressive hiking cycle in history, the Reserve Bank has finally begun cutting interest rates. With cash set to become less attractive to Australian investors, we explore how to position your fixed income portfolio for the rate cut cycle ahead.

For the majority of last year, taming inflation remained the Reserve Bank’s most pressing concern, until flat economic growth in the September quarter prompted a switch to a more dovish stance. While the central bank has taken a conservative approach, awaiting further data to confirm inflation is on a sustainable path back to target, Q4’s CPI figures effectively gave the RBA the green light to change tacks - with its focus now on supporting private sector growth to return.

As trimmed mean inflation rose just 0.5% over the December quarter - versus 0.6% consensus – and 3.2% year-on-year, the decision to cut rates has come as no surprise and markets are also pricing in a 50% chance of a follow-up cut in April.² With around 85 basis points of cuts now priced in for 2025³, the easing cycle is likely to be slow and steady – but it seems the RBA may have pulled off the seemingly impossible feat of an economic ‘soft landing’, moderating inflation with minimal impacts to growth.

As seen in the chart below, the economy is expected to grow moderately over the next two years, supported by public sector spending, population growth and household spending as inflation becomes more subdued. For more detailed projections on the domestic economy, read our Q1 2025 Australian Market Outlook.

Australian GDP Growth forecasts, 2025/2026

Source: Reserve Bank of Australia. Note December 2024 GDP numbers are forecast only – Q4 GDP due for release in March 2025

With interest rates currently at a 13-year high⁴, investors have enjoyed elevated income from cash over the past couple of years. But as rate cuts commence in Australia, now may be the time to consider other fixed income alternatives to position for the next phase of the economic cycle – as outlined in our recent paper, No Time to Yield.

With the RBA cutting rates, the income offered by government and investment-grade corporate bond yields will drop, making high-yield bonds more attractive. Despite some narrowing in spreads in 2024, high yield bonds still offer elevated yields compared to cash rates, making the iShares Global High Yield Bond (AUD Hedged) ETF (IHHY) a compelling option for income-focused investors. As investors prepared to insulate their portfolios for the coming rate cut cycle, we saw almost $100 million in flows to IHHY in calendar year 2024 - placing the fund within the top 5 iShares fixed income ETFs in Australia on an inflow basis.

High-yield bonds tend to do well when interest rates are being cut - such as in 2019, when a series of Federal Reserve rate cuts saw high yield bond spreads narrow and IHHY return 13.2%,⁵ and in 2023, when the Fed paused rates and IHHY returned 10.3%. In 2024, with expected rate cuts, spreads stayed tight, keeping high-yield bonds appealing for income-focused investors. Positive factors such as better credit profiles of issuers and increased long-term investor interest could tighten spreads even more in 2025 (see chart below).

Source: BlackRock, Markit iBoxx Global Developed Markets Liquid High Yield Capped Index, 31/1/2015-31/1/2025.

High yield also provides diversification benefits through access to issuers that do not necessarily overlap with equities or more conservative fixed income holdings – such as pharmaceuticals, healthcare, telecommunications, and automotives. This diversified exposure also helps to reduce default risk, which is expected to decline in 2025 across both US and European high yield bonds⁶ as companies take advantage of falling rates to refinance their debt.

Additionally, high yield bonds’ enhanced income potential and moderate volatility make them a good complement or alternative to income-focused equities, to which Australian investors often turn because of their tax benefits. Looking at the Markit iBoxx Global Developed Markets Liquid High Yield Index, which IHHY tracks, this generated a 1-year total return of 7% in calendar year 2024 with annualised volatility of around 2%, versus an 11% return for the ASX200 with around 8.5% annualised volatility.

For investors looking at domestic options that can optimise income as cash rates come down, but maintain a level of capital preservation, enhanced yield exposures like the iShares Yield Plus ETF (IYLD) can also help to balance these competing needs.

Giving investors exposure to a diversified mix of short-term fixed and floating rate bonds, IYLD aims to provide the highest income for the lowest amount of interest rate risk. The fund currently offers a 12-month trailing yield of 4.66%, compared to between 3.5-3.9% for a major bank 6-month term deposit⁷.

Bond ETFs allow investors to be more precise in targeting their fixed income allocations – in this case, to access higher yields as cash rates become less attractive – for a generally lower cost than active management. In the case of iShares bond ETFs, investors also benefit from the expertise and experience of a global portfolio management team that can take advantage of new bond issues and restructures among issuers, managing over US$25 billion in the high yield space specifically. iShares’ securities lending program can also help to offset expenses for our fixed income investors.

Of course, bond ETFs do come with risks which investors should consider. The bonds held by the ETF have different levels of sensitivity to interest rates based on their coupon rate, yield, and time to maturity. Bonds with longer maturities are more affected by changes in interest rates, which means they carry a higher risk. Investors should carefully consider the duration of their fixed income investments and regularly review and adjust their portfolio to manage this risk.

Given the shifts in economic conditions we may see in Australia this year, when it comes to fixed income, targeting the right sectors of the market is key. With a long and protracted rate cut cycle on the cards from the RBA, we think investors would do well to consider stepping out of cash and looking to exposures that harvest the best available income.