What is the future for bonds and why should you maintain an allocation to this asset class?
The future of fixed income.
Roger Bridges, Head of Fixed Income and Anita Daum, Head of Portfolio Management and the portfolio manager for the Tyndall Australian Bond Fund have provided their answers to AdviserVoice on fixed income and the future for bonds.
Roger has 30 years’ experience in the fixed income market, and has overall responsibility for managing and implementing the strategy for Tyndall’s fixed income portfolios. Anita has 11 years’ experience in the fixed income market and has been managing the Tyndall Australian Bond Fund for four years.
Why did bonds take such a hammering in June?
Roger: The June reaction of bonds was due to the market’s expectation for the reversal of quantitative easing or QE in the US. Bonds prices surged to record highs in recent years, in part due to central banks such as the US Federal Reserve and Bank of England buying them under QE programmes. The intention – and the effect – was to push down bond yields, which move in the opposite direction to prices.
Low bond yields tend to cause interest rates to fall. This helps to reduce the cost of borrowing for consumers and governments and boost the prices of other assets such as shares. These effects can help pull a country out of recession and assist economic recovery.
But as the recovery gathers momentum, central banks try to curtail and then reverse QE, sending the previous trends into reverse. Announcements by the Fed in June that it planned to scale back its QE programme sparked fear among investors, sending bond prices in the US sharply lower and yields higher. Our bond market is strongly affected by the movement of US bonds, particularly longer-dated bonds such as the 10-years. As a result, we also saw a sell-off here with yields rising and bond prices falling below fair value.
Following this upset, the Fed was forced into a partial retreat and tried to calm market fears over QE tapering, which caused bond yields to fall back to more normal levels. In fact, July saw Australian bond market indices post modest positive returns as bond yields fell.
Can we expect more volatility in the short term?
Roger: In our view, September seems to be a likely start date for the US Fed’s tapering of its bond-buying programme. The Fed indicated back in June that it may start tapering next month and recent strong economic data makes this all the more likely. In the past week or two, we’ve seen strong US employment and consumer price data.
Given the strong correlation between the movement of US government bonds and Australian government bonds, bond market volatility remains a strong possibility as the market tries to work out what the effects of tapering QE will be.
As growth improves in the US and this tapering of QE comes into effect, how likely is it that we will see another 1994 with bonds experiencing negative returns?
Roger: It is possible, though unusual, for bonds to deliver negative returns. In general, this only occurs when either the cash rate unexpectedly increases by a large amount or the bond market tries to price in unexpectedly large rate increases and adjusts these expectations quickly. If these market expectations are slowly priced in, then the market value of bonds may fall but they don’t experience negative returns, only lower returns.
This is what happened in 1994: The Fed and its chairman Alan Greenspan were worried about inflation following the 70s and 80s and so decided to take swift action to avoid a spike in inflation. The market was surprised by the sharp rate hikes that the Fed introduced and US bonds didn’t respond until the rate hikes occurred since they were not well telegraphed in advance. The market then panicked and bond yields jumped, while prices fell. 2004-2006 also saw rate hikes in the US but because the Fed was more transparent and took action more slowly, the market had time to react to avoid bond losses.
The current situation is likely to be a repeat of 2004-2006. The Fed is telegraphing its moves in advance so the market shouldn’t be taken by surprise, although there might be brief periods of panic, like in June. But in the longer term, QE unwinding and rate hikes will be slow, measured and telegraphed in advance which shouldn’t lead to bond losses even though the trend will be for yields to rise.
Focusing back on the domestic economy, what’s the likely impact on our bond market of the upcoming Federal election?
Roger: There is unlikely to be much of a reaction. In general, investor confidence should improve if there is a clear-cut outcome, with one party obtaining a decent majority. A hung parliament will be a negative for confidence and add to uncertainty.
Whichever party wins, if they intend to achieve a fiscal surplus, then obviously that will have an effect on bonds due to the reduction in bond issuance. If there are fewer bonds on issue, it should help to support pricing and keep yields lower.
With prices surging to record highs in recent years, is it fair to say that Australian bonds have had their day?
Roger: Given historically high prices and low yields, investors have been questioning whether bonds have had their day. I don’t think this is the case.
Australian 10-year bonds have fallen from around 15% in 1982 to record lows below 3%. The decline in bond yields has been largely the result of a structural decline in global inflation expectations, partly due to QE from central banks around the world and partly to slowing population growth and an aging population.
But in the shorter term, there are three main reasons why Australian bonds should remain attractive.
1) Foreign investment. Even though this has started to drop off, it is still historically very high. Before the GFC approximately 20-30% of our bonds were held offshore, but by this year, it had jumped to just under 80%. This is largely due to other central banks wanting to diversify away from currencies such as the US dollar.
2) QE globally. For Australia, this artificial suppression by other central banks means that there is increased demand for our higher yielding assets. Although interest rates are at record lows, our cash rate of 2.5% is still much higher than the zero or close to zero rates seen in Europe, the UK and the US.
3) Our AAA rating. Australia is one of only 8 countries that has a AAA rating with a stable outlook from all 3 major rating agencies (Standard & Poor’s, Fitch, Moody’s).
So, in a world with a still highly volatile macroeconomic backdrop, the combination of very loose monetary policy in other countries and foreign demand for our debt due to its yield advantage should help to support the bond market in the medium term. We don’t envisage many catalysts that would suddenly push bond yields upwards for a sustained period.
Anita, why should an investor maintain a bond allocation in their portfolio?
Anita: Australians have traditionally invested in shares rather than bonds. But bonds are a valuable component in a diversified portfolio. Bonds tend to perform relatively better in market downturns and when deflation is a major risk. Diversifying a portfolio so that it includes fixed income alongside other assets can help balance returns and reduce overall risk.
Although equities can offer the potential for greater returns more quickly, they involve considerable volatility and the potential for capital losses. Fixed income, on the other hand, offers regular, predictable income with a greater likelihood of capital protection and much more stable returns over the long term. It’s the non-correlation to equities that’s important – bonds should outperform when equities are underperforming and vice versa. So it’s important to have some of a portfolio invested in bonds.
What do you think an investor should look for when choosing a bond fund to invest in?
Anita: If an investor wants a core bond holding to diversify their portfolio, then they should look for a traditional “true-to-label” bond fund to offset the volatility of other market sectors and provide that non-correlation to equities risk.
A fixed income fund should perform well in market downturns, providing the consistency of performance and regular income that investors expect. However, it’s important to note that not all bond funds are the same. For example, some funds are able to allocate large portions of their portfolio to credit. This gave investors in some of those funds a nasty shock during the GFC. Instead of the fixed income portion of their portfolio doing its job and being the outperformer during that time, funds that were very overweight credit actually performed badly and in some cases actually delivered negative returns during that period.
Our flagship bond fund did very well during the GFC because it is a true-to-label fund that is highly risk-aware and designed to deliver consistent performance even through serious market dislocations, when equities are doing badly.
So, it’s important to consider what an investor wants from fixed income and choose a fund accordingly. If it’s a non-core holding and the investor is looking for a higher return and is prepared to take on extra risk, then a fund that is able to invest in riskier securities could be appropriate. But if the investor is looking for a core holding, then they want a conservative true-to-label fund that won’t give them any nasty surprises at a time they can least afford them.
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Disclaimer
This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“TIML”). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The Tyndall Australian Bond Fund ARSN 098 736 255 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (“TAML”). Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest. TIML and TAML are wholly-owned subsidiaries of Nikko Asset Management Co., Ltd.
