Bond market returns over time have less to do with capital gains or losses, they are largely driven by income.

Despite predictions that the end of the bond market is nigh, Lonsec’s income sector has expanded considerably over the past few years.

This growth has been driven by increased demand for financial products that pay regular distributions, the launch of the bond ETF market and an evolution of absolute return focused strategies that tend to have more flexibility to adjust duration and therefore sensitivity to rising bond yields and capital losses.

Lonsec Senior Investment Analyst, Libby Newman, said, “One of the most frequently asked financial adviser questions of the past few years has been ‘should I be getting out of fixed interest?’”

“As yields plummeted, driven by the extraordinary monetary policies adopted by global central banks, the number of articles calling the end of the bond market rose”.

Unlike equities, bonds provide some certainty in terms of their returns – a regular coupon and return of principal at maturity, assuming there is no default.  However, it is still possible for income funds to provide negative returns due to market value fluctuations.

For example, an investor may experience a loss if they are forced to sell when:

• Interest rates (and expectations of future interest rates) go up sharply – and the prices on bonds commensurately fall
• Credit spreads deteriorate (widen).

“However, it is important to remember that bond market returns over time have less to do with capital gains or losses, they are largely driven by income – regular interest payments and reinvestment income earned when cash flows are put back to work in the market,” said Newman.

“Indeed many periods of negative or soft returns are followed by strong years because the coupon interest and bond maturities can now be invested at higher rates.”

“The yield on an Australian Commonwealth Government 10 year bond has risen about 1.0% compared to this time last year, and the capital loss (if yields rise the price of the bond falls) pretty much cancels out the income earned over the year.”

However, there is much more to the debt securities market than Australian and US government 10 year bonds. Over the same period, credit spreads (the premium for investing in a company rather than with a government), have narrowed, so corporate bonds have been able to deliver a positive return, even with the headwind of rising yields.  Then there are floating rate bonds, which are also less impacted by rising yields than their fixed rate counterparts.

“So you can see that Funds that can tap in to the full spectrum can still deliver positive returns and an income stream,” said Newman.

So, should you get out of bonds?

“Well, you’d expect me to say no. Australians own fewer bonds than investors in other parts of the world and want steady income in retirement, so I am pleased to see Commonwealth Government Bonds increasingly visible and available for retail investors to trade. But you definitely need to understand what your bond fund can do before you invest in this type of financial product. ”

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