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?

Have things changed for growth stocks?

Have things changed for growth stocks?

Amidst the carnage of one of the worst starts to a calendar year for share markets around the world, ‘growth stocks’ have taken a ferocious beating.

Growth stocks are those companies whose earnings are expected to be able to grow independently of the broader economy. The classic example is tech companies, where global reach of products and platforms can underwrite revenue and earnings growth even when economic growth is negligible.

The other broad grouping is ‘value stocks’, which are those whose earnings go up and down with the economic cycle.

In the aftermath of the GFC, global growth rates were consistently low and growth stocks dominated share market returns to the point where value stocks experienced their worst ever period of relative underperformance. In the United States, the Russell 1000 growth index more than doubled the return of its value counterpart between the start of 2015 and November 2021.

However, since late 2021, that has sharply reversed with the growth index lagging the value index by around 40 per cent. Some of the highest profile growth stocks that peaked during the COVID lockdown period, such as Peloton and Shopify, fell by more than 90 per cent.

Russell 1000 Growth Index / Value Index

After the shakeout we’ve seen, any smart investor who is remotely contrarian will be sniffing potential bargains. However, before piling into heavily sold growth stocks it’s worth looking at some history and what made the growth stocks perform so strongly in the first place.

First, the history: growth stocks smashed value in the late 1990s until the bursting of the dotcom bubble, and then underperformed for more than a decade. So these cycles can go for a long time. Much depends on the macro factors at work.

And those macro factors, in particular what’s happening with inflation, help explain why growth did so well over the past 10 years. When inflation is declining it will normally mean that interest rates and bond yields are also going down. It is also well established that lower inflation helps to support higher PE (price to earnings) ratios, which is what happened through to late last year.

Also, lower bond yields will help support higher share price valuations. When analysts do a discounted cash flow (DCF) valuation on a company’s shares, they will typically base their discount rate on the 10-year bond yield (plus or minus a bit for risk). The lower the discount rate, the higher is the current value of future cash flows, meaning the higher is the price you’re prepared to pay for the shares today.

When inflation started rising sharply, those tailwinds reversed into mighty headwinds. The US 10-year bond yield shot up from lows of about 0.5 per cent to a recent peak of 3.2 per cent, radically transforming the valuation equation for growth stocks, which has been very clearly reflected in plunging share prices.

Over the past 10 years, every time the growth stocks suffered a setback they quickly bounced back, conditioning investors to buy the dip. What might be different this time is the outlook for inflation. If inflationary pressures persist, that will continue to be a headwind for growth stocks.

It’s frustrating to be told the arguments for inflation persisting are pretty equally stacked, but that’s the case. For example, the increase in globalisation that helped to reduce costs over the past 20 years may well be reversing as companies reassess the benefits of more robust supply chains. Also, the very low unemployment level in both the US and UK has seen wages growth settle at around double the pre-COVID level.

Similarly, if Europe follows through on reducing its reliance on Russian gas and oil, that could impact energy prices, plus resources could be diverted to building more renewable energy generation.

On the other hand, the more renewable energy capacity that gets built, the lower will energy costs be, reducing the cost of production. Plus, over the past 50 years betting against technology has not been wise and technologies such as AI and 5G could be transformative.

The upshot is nobody can be certain where inflation will be in a year or two, meaning nor can we be certain that growth stocks will bounce back like we’ve seen in the past. There are definitely bargains, and we may well see a bounce back from oversold levels, but for sustained performance, smart investors could be well advised to hedge their bets by retaining a balance between growth and value stocks.

To fix or not to fix

To fix or not to fix

The variable versus fixed mortgage rate decision will affect a homeowner for years to come and could be the difference in thousands of dollars of accrued interest. 

At its May meeting, the Reserve Bank of Australia acted to curb soaring inflation by raising the official cash rate by 0.25%. With Governor Lowe warning that this is expected to be the first of many rate hikes over the next 12-18 months, many are wondering if they should fix their home loan to safeguard against rising rates. The right answer depends on your unique situation and tolerance for risk. 

Let’s start by looking at the advantages and disadvantages of each.

Variable rate loans

  • The main advantage is flexibility.
  • Unlimited extra repayments which will help you pay your loan off sooner.
  • It takes advantage when interest rates are decreasing by lowering interest repayments.
  • Allows you to refinance or restructure your loan at any time, for example, by accessing excess equity for renovations.
  • Variable home loans generally come with more features such as a redraw facility or offset account.
  • When interest rates rise, so too do your repayments.
  • As interest rates can change at any stage you lack a level of certainty over what your repayments will be in the future. This can make detailed budgeting quite challenging.

Fixed rate loans

  • The main advantage is payment certainty, allowing you to budget your repayments for the foreseeable future. This leads to a greater sense of financial security.
  • Your interest repayments will be lower if, during the term, the variable rises above the fixed rate.
  • Most fixed rates limit extra repayments to around $5,000 per year therefore if you benefit from a lump sum of cash, like an inheritance or bonus, you cannot place this directly onto the loan without penalty.
  • You do not benefit when interest rates go down during the term of the fixed loan.
  • There are penalties for breaking a fixed rate before maturity which makes restructuring or refinancing to another lender much more expensive. These penalties also apply if you sell your property within the fixed rate term.
  • Fixed rates generally do not come with additional features such as a redraw facility or an offset account.

As you can see, there is a lot more to consider than simply a bet on where interest rates are heading.

After considering these characteristics, if the certainty of fixed rate repayments is still appealing you should then consider whether you will likely be better off with the fixed rates on offer.

A common misconception is that if the variable interest rate rises higher than the fixed rate over the term of the loan then you will pay less interest. Of course, there are periods during the term when the variable rate will be lower so you must instead consider the average rate over the term. Take an example where a rate was fixed 1% above the current variable rate for a period of 2 years. After 1 year the variable rate had steadily risen to meet the fixed. To break even, the variable would need to continue to rise another 1% (approx.) over the final year of the term. When calculating the exact breakeven point, you must also consider the timing of the rate rises and that the loan balance may steadily decrease over the term.

The calculations in the table above are based on a 30 year $800,000 loan with monthly principal and interest repayments.

Hedge your bets

Often borrowers are drawn towards the certainty of fixed repayments but do not want the additional payment restrictions that come with it. By splitting the loan, you can essentially enjoy the benefits of both. To calculate the variable split, you should consider how many extra repayments you are likely to make over the term of the fixed rate as well as how much your balance will reduce by your regular payments. A good mortgage broker can help you with this calculation. You may also consider an even split if you are undecided which rate will work best for you.


If you’d like to discuss your specific circumstances, or simply interested in what fixed rates are available, please do get in touch.

Open banking: What this means for you and your data

Open banking: What this means for you and your data

Open banking is widely regarded as the most significant change in the retail banking landscape for decades but many of us have never heard of it. So what is it and how does it affect me?

Whilst the term originated from Europe, Australia passed the Consumer Data Right (CDR) legislation in August 2019 which gave consumers exclusive right to their own data and enabled them to choose whether to share it with third parties. In the following years the banks and other lenders were forced to securely share some of their banking data with other accredited data recipients (ADR). The types of data include details of home loans, investment loans, personal loans, transaction accounts, closed accounts, direct debits and scheduled payments, as well as payee data. It’s important to reiterate that this data cannot be shared without the consent of the customer.

So how does this change things?

By ensuring that consumers have exclusive right to their own data, according to the Australian Banking Association (ABA), benefits to customers will include;

  • Streamlining the application process for certain financial products
  • Saving significant time and administration when switching from one bank to another
  • The availability of more products tailored to your particular financial circumstances

The changes are aimed to promote more competition within the financial services industry providing smaller tech based emerging companies the data to efficiently design products that better suit their customers. Imagine applying for a loan or credit card where, in a few clicks, your savings and credit data is used to immediately approve your application and determine the rate you are offered. There is no need to provide any supporting documents and the lengthy processing delays which have hampered the industry for years are a thing of the past.

How secure is my data?

To receive and share your data an ADR must become accredited by the Australian Competition and Consumer Commission (ACCC) to ensure they have the required level of security and data privacy settings. This process can take as long as 4-6 months and involves significant upfront and ongoing legal and labor costs. For a long time the cost of accreditation, and ongoing regulatory maintenance, was seen as a barrier for smaller companies to access the data. To overcome this, last year the Australian government approved a representative model which will come into effect this month.

As mentioned earlier consumers will need to provide consent for ADRs to access their data and the information will be deleted or de-identified after a maximum of 12 months unless permission is once again granted. You can also withdraw your consent at any time and your data must be deleted immediately. Each company that you grant permission should always provide you with the following information:

  • What information you’re sharing and how it will be used
  • Who will have access to your data
  • How long they’ll have access to your data for
  • How you can manage and withdraw consents

When will I see the benefits of this?

The type of data available has been rolled out in phases since July 2020 but open banking is still considered to be in it’s infancy.

An important milestone will occur this month when joint accounts are brought under the scope of CDR. As you can imagine this represents a huge change for the mortgage industry where a significant proportion of loans are held in joint names.

From November 2022 energy companies will also need to provide customers with access to their usage and connection data. This will kickstart a future where comparing energy providers based specifically on your usage can be performed at the click of a button. It also gives future providers the opportunity to tailor your energy charges specifically for you.

As the number of data sources increase the consumer will progressively see the benefit but until then, with many data sources such as superannuation and investment accounts still unavailable, companies utilising the data will typically operate under a hybrid model combining open banking and traditional sources of information.

The January correction explained

The January correction explained

January saw the biggest correction in financial markets since the COVID selloff in February 2020. What happened? What caused it? And what’s the outlook?

The numbers

Share markets across the world declined over the month of January. The table below shows how far different markets fell from their recent highs, which in some cases was late December and in others was early January, and how they ended up on 31 January compared to the same recent high.

The numbers_image1

It is striking the extent to which some markets have already bounced back, although it is too early to declare the correction is necessarily over.

What caused the selloff?

The selloff started because markets expect central banks to increase interest rates in response to rising inflation.

Australia’s inflation rate hit 3.5% in the December quarter of last year, after 3.8% in the September quarter, the highest in the post-GFC period.

However, it’s the US, where the CPI hit 7% in December last year, the highest since 1982, that has markets really spooked. Some of the year over year price rises include energy +29%, gasoline +50%, used cars and trucks +37%, plus food and shelter costs rose sharply as well.

Exactly what causes inflation is always tricky to work out, but this time it’s easy to point to at least one major contributor. The US government injected COVID stimulus equivalent to 25% of GDP, which saw personal incomes increase massively at a time when companies had sharply reduced forward orders in anticipation of a drop in demand. While spending initially dropped, it bounced back quickly – see chart 1.

Chart 1: US personal income increased sharply with government stimulus and spending followed soon after

Chart 1_Trillion of chained 2012 dollars

Because people were in lockdown, spending on services plummeted and has only slowly recovered, but spending on goods exploded – see chart 2.

Chart 2: Spending on goods rocketed when people were in lockdown

Chart 2_Personal Consumption Expenditures

A lot of those goods being bought had to be imported from Asia, however, at the same time, a chronic shortage of shipping containers saw prices jump from US$3,000 for a container from China to the US, to as high as US$20,000. Then there was the problem that a lot of US transport workers were either calling in sick or quitting their low-end service jobs, so supply chains quickly got clogged up, from ports to warehouses.

Semiconductors quickly became scarce and auto manufacturers, who had cancelled contracts with the semiconductor manufacturers, were left with tens of thousands of almost finished cars at a time when demand for new and used cars took off. Consequently, car prices jumped.

Then US companies reported record margins at the end of the year, so evidently they seized the opportunity to raise prices and pass them on to consumers.

The upshot, goods inflation, having been negative for the past 25 years thanks mainly to technological advances and low wages growth, has rocketed – see chart 3.

Chart 3: Goods inflation has taken off after 25 years of being negative

Chart 3_Annual PCE inflation

After initially insisting inflation was only ‘transitory’ and therefore wouldn’t require a near term response, the Federal Reserve has been forced to back down in the face of a relentless barrage of criticism from financial markets. The quantitative easing measures that were put in place at the onset of the COVID crisis are being wound back and the governor, Jerome Powell, all but confirmed the Fed will raise interest rates at their March meeting. In fact, he left the door open to multiple rate rises this year and the market is pricing in at least three.

Here in Australia the RBA has also insisted it would not be raising rates until 2024, but speculation is mounting they will reconsider that position in their meeting on February 1 and the market is pricing in four rate hikes by the end of the year.

Why has that affected the share market?

When interest rates are super low, typically so too are bond yields, which has two effects.

First, when returns from bonds are super low it’s an easier decision to invest into shares.

Second, when you value an asset, you try to work out what all its future cash flows are worth today, which is referred to as a ‘discounted cash flow’ (or DCF) valuation. To calculate a DCF, you use a ‘discount rate’, which is typically based on the 10-year bond yield. The lower the discount rate, the higher is today’s value of all those future cash flows, and vice versa. So with higher interest rates and higher bond yields, those DCF valuations will be going down.

That affects the so-called growth stocks the most because you are typically placing a much higher emphasis on earnings a long way into the future.

That’s why the NASDAQ in the US got whacked the hardest, it’s full of tech companies. In fact, there’s a bunch of the real blue-sky companies, such as Zoom, Peloton, and Zillow, that fell 60-80% from their highs of early last year.

Should we be panicking?

Definitely not. While nobody, but nobody, can tell you when this correction will end, if it hasn’t already, there are many indicators that suggest economies and companies are in good shape. After all, the fact interest rates are rising is because the economy is growing strongly. Indeed, US GDP grew at an annualised rate of 6.9% in the December 2021 quarter, the highest in more than 25 years (with the exception of the freak September 2020 quarter, which was a bounce back from the COVID lockdowns) – see chart 4.

Chart 4: US GDP growth is the highest in decades (except for the post-COVID crisis spike)

Chart 4_US GDP growth

It is entirely normal for share markets to experience a correction, with the average intra-year pullback for both the Australian and US markets being 14% – see charts 5 and 6. Last year was the exception, where the worst drawdown in the US market was only 5% and in Australia was 6%.

Chart 5: Average intra-year drawdown for the Australian market is 13.9%

Chart 5_Average intra-year drawdown

Chart 6: Average intra-year drawdown for the US market is 14%

Chart 6_Average intra-year drawdown

As inevitably happens with any correction, you may have heard or read stories quoting uber bearish market pundits forecasting the end of the world. One example is Jeremy Grantham, who was widely quoted as predicting the market will fall at least 50%. The simple fact is, Grantham has been making that call since 2013 and has been wrong the whole way.

Something we all need to be aware of is that the media loves a crisis, because they know we’re hardwired to be drawn to headlines screaming “DISASTER AHEAD”. Without doubt they turn up the noise associated with selloffs, and likewise with the recoveries. It’s best not to pay much attention to most things you read and hear in the mainstream media.

Indeed, far from panicking, it’s worth remembering corrections like the current one usually throw up interesting opportunities. Markets have a way of picking themselves up, dusting themselves off and carrying on with their journey from bottom left to top right – see chart 7. It’s interesting to look at that chart and see some of the past events that at the time seemed like we may never recover from, but we do. The current concerns about Ukraine probably fall into that bucket.

Chart 7: Markets have a way of recovering and carrying on

Chart 7_Growth of $1

In conclusion, the current correction is because of concerns that rising inflation will cause central banks to raise interest rates, which affects share valuations, especially for the more growthy stocks. Buyers already appear to be snapping up cheaper stocks, which may indicate the market has already priced in what it believes is the rate rise risk. Nobody can tell you whether this correction has run its course, but you can rest assured the market will recover.

If you have any questions about what markets are doing or how your portfolio is positioned, please call us today.