What’s the best way to take advantage of the multi-year selloff in bonds?

What’s the best way to take advantage of the multi-year selloff in bonds?

It’s never happened before: bonds are about to deliver a third year of negative returns. The BofA Merrill Lynch 10+ Year Treasury Total Return Index in the US was recently more than 40% off its highs – more than double its previous worst drawdown. 

It’s left a lot of shell-shocked investors scratching their heads wondering how what’s supposed to be the defensive part of a portfolio could perform so badly, and a whole lot of other investors wondering if there are bargains to be had.

Why were bond returns negative?

The first thing to know about bonds is that inflation is like kryptonite for them. If investors believe inflation is going up, they will demand higher compensation in the form of a higher yield.

The second thing to know is if you hold a government bond to maturity you are assured of getting the principal back, which is always a face value of $100 per bond.

When a plain old government bond is first issued, the interest rate it will pay the holder (which in bond speak is called a ‘coupon’) is fixed and doesn’t change over the life of the bond.

If you bought a newly issued Australian 10-year government bond today you’d receive a yield of about 4.6 per cent per year, and after 10 years you’d get $100 back for each bond. So the annual return is dead easy to calculate: 4.6 per cent.

However, if you wanted to sell that bond and inflation expectations have gone up since it was issued, any potential buyer will insist on a higher yield. Because the coupon is fixed, the only way to compensate the buyer is to reduce the price of the bond. Then, if the buyer hangs on to it until maturity, they’ll get the $100 back but on a lower entry price, thus compensating them.

Since the inflationary outbreak of the late 1970s and early 1980s, inflation has trended downwards over the medium to longer-term, which has been fantastic for bond investors, because the price of those bonds has risen over that medium to longer-term – see chart 1.

Chart showing bond yields trended down, resulting in a 40-year bull market, which went into reverse in mid-2020

However, the inflationary outbreak of the past few years has thrown that into reverse, and as expectations of higher inflation and interest rates has grown, so the price of bonds has fallen.

Is it time to hunt for a bargain?

It’s hardly surprising that any investor accustomed to market cycles would look at an asset that’s dropped 40 per cent and presume there’s a bargain to be had, and there are bond fund managers banging the table insisting now is the time to be buying bonds. But, as with anything in financial markets, unfortunately it’s not that easy.

Government bonds are issued with different lifespans, from 90 days to 30-plus years. The most popular bond yield that gets quoted is the 10-year bond.

The longer-dated the bond, so the more life it has until it matures, the more volatile it will be. The fancy name for that is ‘duration risk’, and it’s something that can be worked out for every bond. Australian 10-year government bonds currently have a duration risk of 8.7, which means if the yield increases by 1 per cent, the price of those bonds will fall by 8.7 per cent, and vice versa.

It’s that duration risk, and the volatility it causes, that’s the trickiest part about investing in bonds, even after they’ve copped a beating.

For a real world example, you can buy an Australian government bond through the ASX. A quick Google of “ASX listed bonds” should take you to the page that lists them. There’s one with the ticker GSBG33, which was originally a 20-year bond issued in 2013, so it has 10 years left until maturity. As you’d expect, its current yield is pretty much bang in line with the quoted 10-year yield, so about 4.5 per cent, and its last traded price was around $100. In other words, what you’d expect from a 10-year bond.

However, in August 2019, that same bond was trading at a price of $147, and at the start of November it was $97, so its price had dropped by 34 per cent – see chart 2. That’s some serious volatility for a supposedly defensive asset; clearly, it’s only defensive if you are certain you’ll hold onto it until maturity, in which case you’ll receive a return of 4.5 per cent, which compares to the September inflation rate of 5.4 per cent.

Chart showing the Australian government bond, GSBG33, has experienced higher 
volatility than what many would associate with a defensive investment

For a long-dated bond to provide a better return than 4.5 per cent will require inflation expectations to fall, which is likely to happen if the economy slows down or goes into recession, and importantly, that extra return will effectively come from the price going up, so capital growth.

There are shorter-term bonds, that have lower duration risk and are therefore not as volatile, but the yield is lower. Alternatively, for investors purely interested in locking in a yield, term deposits are now paying as much as 5.25 per cent for 12 months and come with a capital guarantee. The risk you run there is it’s only good for 12 months.

You can also buy bond ETFs, however, they never mature. The ETF will always have some duration risk in it, meaning it will always be potentially volatile.

Another option is to invest through a fixed income fund manager and leave it to their expertise. There are some that specialise only in government bonds and others that operate under a more flexible mandate and can invest in corporate bonds as well. Andrew Papageorgiou, a portfolio manager at Realm Investment House, argues credit spreads on corporate bonds are historically far less volatile than interest rates. Also, good managers can employ fancy strategies to minimise the effect of volatility by using derivatives.

It’s possible those arguing it’s a great time to buy bonds are affected by recency bias: it wasn’t so long ago bond yields were negative, how can they possibly stay above 4.5 per cent? But bond yields don’t necessarily mean revert, the recent downward trend went for 40 years. There are legendary bond commentators, like Jim Grant and Barry Eichengreen, warning of a multi-decade bond bear market.

What’s more, investing in bonds to back a view that yields will decline is effectively targeting a capital return, which rings of a growth investment, whereas bonds are normally part of the defensive fixed income part of a portfolio.

On the bearish side of the fence are the many economists arguing rates will stay “higher for longer”. It really depends on what happens to inflation, and if smart investors have learned nothing else over the past couple of years, it should be that trying to guess where inflation will be years from now is a mug’s game.

If you would like to discuss your investment options, please get in touch.

How to get your head around fixed income

How to get your head around fixed income

Article featured in the AFR

Fixed income returns over the fiscal 2022 year were the worst on record. When share markets experience returns like that investors have understandably become conditioned to look for bargains, but fixed income markets don’t necessarily work the same way.

Any well diversified portfolio will include defensive holdings designed to reduce its overall volatility and cushion the effects of falling share markets. Fixed income investments normally play that role, and that typically means allocating to government or corporate bonds, which are two very distinct markets, driven by different factors.

Because bonds issued by governments of developed nations are almost certain to be repaid, the price they trade at is not normally influenced so much by their credit rating as the outlook for inflation in their home country. If the market expects inflation to rise, investors will demand a higher yield to compensate, which requires a lower price and vice versa.

By contrast, while inflation also plays a role in pricing of corporate bonds, credit risk is the biggest issue, that is, the risk the company defaults and you don’t get your money back. Consequently, corporate bond prices are more sensitive to the outlook for recession, when company earnings come under increased pressure. The more investors are worried about recession, the higher the premium, or credit spread, to investing in risk-free government bonds they will demand.

Andrew Papageorgiou, managing partner at Realm Investment House, explains, “Just like bargain hunting in the share market, there are short and long-term considerations for fixed income investing. However, unlike the share market, fixed income markets have nuances that are only revealed through information that’s tough for non-professional investors to get their hands on.”

For example, in considering whether it’s a good time to invest in Australian government bonds, it helps to know that, according to the swaps market, inflation is currently forecast to average 2.6 per cent over the next 10 years. If the 10-year bond is yielding 3.15 per cent, that gives you a ‘real’ yield (after inflation) of 0.55 per cent. Is that a fair return? The average real yield over the past 15 years was 0.8 per cent, which makes it look a little low, but the post-GFC average has been 0.13 per cent, which makes it look much better.

In the US the current real yield on 10-year bonds is minus 0.05 per cent, which sounds pretty lousy, but the post-GFC average has been minus 0.17 per cent. Still, with the uncertainty around inflation, a negative real return is tough to swallow. For instance, in June, the real yield was 0.5 per cent, but since then inflation expectations have tumbled.

Meanwhile, credit spreads, or the risk premium, for Australian corporate bonds are as high as they were during the March 2020 COVID crisis. Papageorgiou points out that’s not a good reflection of the current perceived risk of recession, especially compared to the crazy time of early 2020, but is more to do with technical factors. So parts of that market look attractive, particularly compared to the US, where credit spreads are much less generous.

For the longer-term outlook, Damien Hennessy, of Zenith Investment Partners, says the current market signals around whether inflation has peaked, or economies will recess are so mixed that it’s difficult to view fixed income as a set and forget strategy right now. He points out that bond yields in June spiked to levels where he recommended reducing underweight positions but have since fallen again making them less attractive.

For investors who are game to increase their allocation to fixed income, just like with shares, there are passive and active options. Rather than trying to pick individual bonds, which introduces concentration risk, a fund will provide diversification. For passive investors, Vanguard offers both Australian and international government bond ETFs, credit ETFs and blended ETFs.

For investors who prefer to leave the decisions to professional managers, there are many to choose from. A good adviser will be able to help with curated recommendations.

For investors who see fixed income markets as just too uncertain, one option for the defensive portion of a portfolio is cash, which also provides flexibility for picking up bargains. However, with inflation currently many times higher than the bank interest rates on offer, it is guaranteed to lose purchasing power.

Portfolios always benefit from holding defensive assets to protect them against volatility, and over the past 40 years the long-term decline in interest rates has been very kind to smart investors. However, just as with equities, the uncertain outlook for inflation is a game changer.

At Steward Wealth, we went underweight both government and corporate bonds a few years ago and instead invested into ‘private credit’, that is, deals that are not open to the public at large and are usually senior secured mortgages over building and property developments. These loans have the dual benefits of not trading on public markets, so their value doesn’t go up and down like a bond, and they typically pay generous interest of between 5-8 per cent per annum.

Those loans carry their own risks, which have become evident this year with several high profile construction companies going bankrupt. However, we are in regular contact with the lenders and feel comfortable with their assurances that their screening and due diligence processes have become even more stringent. At the same time, the commercial banks have reduced lending to the sector which is throwing up lots of very attractive opportunities at higher rates of return.

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