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.

Want to discuss your investment strategy with a specialist?

Guide to superannuation threshold changes

Guide to superannuation threshold changes

Changes to superannuation thresholds from 1 July 2021 to 30 June 2022

Transfer Balance Cap

The transfer balance cap rules commenced on 1 July 2017. It is a limit on the amount of superannuation a member may use to commence a tax free pension in retirement phase. It is also the level at which you may not make any further non-concessional superannuation contributions. From 1 July 2021, this transfer balance cap will increase from $1.6 million to $1.7 million.

Non-Concessional Contribution Cap

The non-concessional superannuation contribution cap will also be indexed up from $100,000pa to $110,000pa and so the 3 year bring forward rules will enable you to make a $330,000 non-concessional contribution.

Concessional Contribution Cap

The concessional superannuation contribution cap will also be index up from $25,000pa to $27,500pa. Concessional contributions include employer SG (super guarantee), salary sacrifice or deductible super contributions.

Superannuation Guarantee (SG)

The contributions you will receive from your employer will rise to 10%pa from 1 July 2021. Employers will need to pay this on salaries of up to $58,920 per quarter.

The increase in contribution limits is always a noteworthy event, given it tends to only occur every 4-5 years. For those considering utilising the 3 year bring forward provisions, it may be worth considering deferring these payments for 6 weeks. This also applies to those who were considering using their superannuation to purchase a retirement income stream prior to 1 July 2021. If you would like to discuss these changes and how to best take advantage of them, please feel free to contact us. We will be more than happy to assist.

Why hybrids offer defensive potential but have strings attached

Why hybrids offer defensive potential but have strings attached

This article appeared in the Australian Financial Review.

When the best term deposit rate you can get is below 1% from a bank you may never have heard of, the chance to get 4% or better on a hybrid security from one of the big four tends to grab your attention. The problem is, of course, those attractive rates come with all kinds of strings attached.

After emerging 25 years ago as a handy solution for companies to raise money and for share market investors to be able to access higher yielding securities, hybrids have become an entrenched part of the Australian market. However, while they can readily play a role in a smart investor’s well-structured portfolio, they are devilishly complex. There is a variety of structures and features requiring issuing documents that can run into the hundreds of pages, enough to prompt government websites like Moneysmart to describe them as ‘very risky’.

The ‘hybrid’ label is because they blend elements of debt securities and equities, that is, they are part bonds and part shares. Typically they promise to pay a rate of return, which you can think of as an interest rate, for a certain period of time, and at the end of that period, the investor gets the original face value of the security, which is normally $100, in shares.

The interest rate is usually quoted as a margin above the 90-day bank bill rate. Companies with a lower credit rating will have to pay a higher margin, just like a corporate bond. The rate can be fixed at a specific return, or it can ‘float’, meaning if the bank bill rate goes up or down, so too does the interest rate the investor receives. And hybrids commonly incorporate franking credits as part of the yield.

The rate a hybrid pays when it’s issued will normally be set by the issuer’s investment bankers going out to the market and testing investor appetite. Then once the security is trading on the market, the rate an investor receives will depend on the price they pay for the hybrid.

The part that makes hybrids complex and risky is the equity element. No two hybrids are the same, and the obligations of the issuer and the rights of the investor, can vary considerably. Some hybrids allow the issuer to stop paying any interest if it falls into financial difficulties, and some place the investor’s rights to recover their money in the event of the company failing behind all other creditors.

The theoretical price a hybrid security should trade at is determined by the combination of its starting margin over the bank bill rate, its different equity-type features and the length of time before it matures. The longer the time to maturity, the more time there is for something to go wrong and so the higher should be the interest rate.

The upshot of all these features is that hybrids are normally a lot more volatile than pure fixed income investments, but not as volatile as shares. When the ASX 200 fell 37% in February and March this year, the Betashares Active Hybrids ETF (HBRD) dropped by just over 15% and is now getting back to its pre-COVID levels, while the broader share market is still 14% below it.

Andrew Papageorgiou, a portfolio manager at credit investing fund manager Realm Investment House, said, “While hybrid prices do fluctuate, they are underpinned by solid mathematics. Like all securities, from time to time prices can be considerably above or below where we calculate they should be, which creates opportunities.”

This begs the question: if a self-directed investor doesn’t have access to the maths, how do they know when hybrids are cheap or expensive? The various stockbrokers that help sell new issues usually publish research showing the basic valuation measures, such as the current yield, and some of them may offer recommendations.

It’s worth bearing in mind, however, those brokers get paid commission to sell hybrid IPOs (an exception that was carved out from the recent reforms that saw LICs and LITs stop paying commissions), so there is an overarching question of conflicts of interest. There are other websites, such as yieldreport.com.au, that publish tables as well. Papageorgiou says a very rough rule of thumb is that normally bank hybrids, which dominate the Australian market, should generally trade at a margin of about 3.2 to 3.3% over the bank bill rate.

A few years ago Australia’s bank regulator, APRA, introduced clauses into bank hybrids enabling them to stop interest being paid or even to compulsorily convert the hybrids into shares if the bank’s senior equity falls below certain levels. ASIC expressed great concern that investors wouldn’t understand the risks and that hybrids were being marketed as an alternative to term deposits. To be clear, buying a bank hybrid is nothing like placing a term deposit with the same bank. A term deposit is government guaranteed (up to $250,000) and its value doesn’t change on a day to day basis.

However, asset allocation consultant, Tim Farrelly, argues the kind of market events required to trigger the conversion clauses are so extreme, and APRA is sufficiently vigilant, that investors shouldn’t lose sleep buying a bank hybrid provided they are comfortable holding it until maturity. That way they can ignore the market volatility and enjoy the added yield of a defensive, investment grade security. If you don’t think you can stomach the potential for 15% drops in the defensive part of your portfolio, no matter how temporary, then don’t go there.

Want to find out more about your investment options and whether hybrids could work for you? Get in touch today.

What you need to know about fixed income

What you need to know about fixed income

This article appeared in the Australian Financial Review

Every interest rate cut is another turn of the screw for investors looking for a decent, low risk return. Many a risk averse investor is finding they’re no longer able to rely on cash or term deposits to generate a reasonable return, and are instead considering other fixed income alternatives, of which there is an almost bewildering range. As usual, however, for every extra percent of return you try to get, you have to accept higher risks, so to avoid nasty surprises, you need to understand what those risks are.

 The explosion in the number of fixed income managed funds, ETFs and LICs over the past couple of years has come as product providers sniffed an opportunity to meet the demand for income in a low interest rate environment. According to BetaShares, in F2019 more money went into fixed income ETFs than any other category, in fact, 60% more than Australian equities.

Investors need to be aware the name ‘fixed income’ covers an enormous range of products, and they come with an equally enormous range of risk. The last thing a risk-averse investor should be doing is dumping a bunch of money into the highest yielding fixed income product they can find, without knowing what they’re getting in to.

Here are some basics to help you understand what you’re buying:

  1. What is a bond?

A bond is a security that a government, or some other kind of entity like a company, issues that says ‘if you lend me $100 today, I’ll pay you an interest rate on that money (the yield), and every year I’ll pay you the coupon (the technical name for the amount of money paid, so if you have a $100 bond with a yield of 10%, the coupon will be $10) every year until the bond matures (it could be anything from 30 days to 100 years), and at the end of the bond’s life, I’ll give you your $100 back.’ It’s similar to a term deposit, except being a security, it can be bought and sold.

  1. A bond’s maturity is usually fixed

Most bonds, especially government bonds, will have a set maturity date. There are some perpetual securities but they’re few and far between.

  1. A bond’s yield will reflect the issuer’s credit worthiness

The less risk you’re taking to get your money back the less yield you’re going to receive. That can be reflected in an issuer’s credit rating from a company like Moody’s or Standard & Poor’s, but other factors also come into it. Interestingly, there are only 11 countries with a AAA credit rating from S&P, Australia being one of them, while the US’s rating is only AA+.

  1. Bond yields can be fixed or floating

A bond’s yield can either be ‘fixed’, meaning it will pay the same coupon until it matures, or ‘floating’, meaning the coupon will be above some kind of benchmark (like the Bank Bill Swap Rate or LIBOR) and will be reset to reflect that rate from time to time.

  1. Bond prices are not fixed

Bond prices can fluctuate, a lot. The average investor is almost certain not to buy an actual bond, but instead will invest in a fund or ETF, and it’s important to realise a fund’s unit price can jump around, depending on what kind of fixed income securities it invests in.

  1. What makes a bond’s price change?

There can be a number of factors, but the main influence is expected inflation. If the market thinks inflation is falling, as it has recently, it will happily accept a lower yield to compensate for the reduced risk of the value of any future payments being eroded by inflation. If a bond’s coupon is fixed, meaning a 5% bond will pay no more or no less than $5 per year for every $100 bond, then it’s the price you pay for the bond that will increase instead. This is where you end up with the what seems weird at first: as a bond’s yield goes down, its price goes up, but in fact, it’s exactly the same as shares: if a share price goes up, its dividend yield goes down.

  1. Duration risk: the bond price’s sensitivity to changes in yield

A bond’s ‘duration’ tells you how much the price should change when the yield changes. For example, according to JP Morgan, the Australian bond index has a duration of 5.4 years, which means if interest rates go up by 1%, the price should fall by 5.4% (and vice versa if rates go down).

That’s really important because the longer a bond’s life, in normal times the higher should the yield be, which appeals to income-oriented investors, who are normally more conservative. However, while a bond’s maturity and duration are not the same thing, the longer a bond’s life the more duration risk it has, and with interest rates already so low, there is heightened risk they could go back up, and even if that’s only by a little bit, those longer bonds could lose a fair bit of their value.

  1. Credit duration: the bond price’s sensitivity to changes in ‘credit spreads’

Bonds issued by a company will typically pay a yield premium to reflect the increased risk that you might not get your money back. That premium is normally calculated as a certain percentage above some kind of benchmark, like the 90-day bank bill rate, and the gap between the two is called the credit spread.

‘Credit duration’ measures how much the price of the bond will change if the credit spread changes; a bond with credit duration of 3 years will fall 3% if the credit spread goes up (widens) by 1%, and vice versa.

Bonds have had an extraordinary start to the year, with the benchmark Bloomberg Composite Index rising 6.5% to the end of June. But almost all that return is because bond yields have fallen, with the 10-year Australian government bond yield dropping a full percent to 1.32% to the end of June, and it’s now even lower at 1.09%.

In fact, bonds have been a great investment since the GFC as yields have plumbed record lows. If you’re going to invest in fixed income securities now, you are, in part, placing a bet that yields will continue to fall, which may or may not happen. For investors looking to replace term deposits, you just need to keep in mind that fixed income does not necessarily mean low-risk.