Global bond bear hug: Investing in fixed income

Financial markets

• Bonds are defined as fixed income investments issued by corporations or governments to raise funds to finance projects and operations. When investors lend money to companies or governments (the bond issuer), they typically receive regular interest or coupon payments with the ‘face value’ paid at the bond’s maturity, but the investment is subject to interest rate, default and credit risk.
• It has been a difficult year for bond market investors encountering the worst downturn since at least the 1970s, as global central bank policymakers lift interest rates aggressively to combat the highest inflation rates in four decades. Heightened geo-political risks and global economic growth concerns have also influenced bond prices.
• With bond prices falling and yields increasing, the Bloomberg Global Aggregate Bond index (unhedged) has declined 23.8 per cent from its record high in early 2021 in US dollar terms. For Aussie investors, the Bloomberg AusBond Composite 0+ Year index has dipped 9.1 per cent in Aussie dollar terms since the beginning of 2022 through to October 28, 2022. And 10-year government bond yields are hovering around 4 per cent in both the US (4.01 per cent as at October 28, 2022) and Australia (3.77 per cent as at October 28, 2022).
• With global central banks aggressively ‘front-loading’ interest rate hikes, most investors expect the current monetary policy tightening cycle to conclude sometime in 2023 as price pressures ease. With the increasing potential for recessions increasing, investors may turn their attention back to ‘safe haven’ bonds, with prices expected to stabilise and recover. Also, bond valuations have cheapened, while potentially offering higher income to investors.
• Investors considering an allocation to bonds can access the asset class through a broad range of Exchange Traded Funds (ETFs) listed on the Australian Securities Exchange (ASX). The portfolio of bonds typically consists of investment grade corporate and government bonds, offering yields above the official cash rate, and are often negatively correlated with shares and other asset classes, providing diversification benefits to investors.

What is a bond?

• Aussie bond or fixed income markets typically garner less media and investor attention in Australia than their better-known sharemarket counterparts.
• So what is a bond? Well bonds are defined as fixed income investments issued by corporations or governments to raise funds to finance projects and operations.
• When investors lend money to companies or governments, (who issue the bonds), they typically receive regular interest or coupon payments with the face value paid at the bond’s maturity. The bond is issued with a face value and length or term of maturity with a promise to repay the issue price at a specific time. Interest or coupons are usually paid quarterly or every six months at either a fixed or floating rate or return.
• Fixed-rate bonds will typically receive the same income payment for the life of the bond. Floating Rate Notes (FRNs) pay a fixed margin above a reference rate, for example the Bank Bill Swap rate (BBSW), irrespective of where the reference rate is set.
• Importantly, a bond’s market price prior to the maturity date can vary from its face value. But the bond’s price will be affected by factors including changes in interest rates, the credit or default risk of the issuer, the level of liquidity, and the time to the bond’s maturity.
• Bond prices and yields move inversely and in opposite directions. The yield is defined as a bond’s internal rate of return (IRR), expressed in percentage terms, accounting for both the income, or coupon paid with the difference between the current market price and face value of the bond to be paid at maturity.
• Another useful measure to value bonds is the Yield to Maturity (YTM). The YTM calculates the average annual return of a bond from when you buy it at market value until maturity, assuming that you reinvest coupon payments in the bond at the same interest rate the bond is earning.

How can investors gain access to bonds?

• The primary issuers of bonds in Australia are governments and companies. Investors can gain access to unlisted bonds through several channels, including
• Australian Government Bonds (AGBs) represent sovereign debt issued by the Federal Government. The bonds typically guarantee a rate of return if held until maturity, and can be bought on the Australian Securities Exchange (ASX) at market value with a brokerage fee incurred.
• The Federal Government also issues inflation-linked or indexed bonds with coupon payments and the face value of the bonds increasing in-line with changes in the Consumer Price index (CPI).
• Semi-Government bonds (semis) are semi-sovereign debt issued by Australian states and territories, bought and sold through treasury corporations.
• Corporate bonds are primarily issued and traded on the over-the-counter (OTC) market. The minimum amount required to trade is typically up to $500,000. As with government bonds, investors will recoup the face value of the corporate bond at maturity unless the issuer defaults. But investors should consider the credit risk of corporate bonds before they buy, while consulting  the issuer’s prospectus and product disclosure statement (PDS).
• Investors can also gain access to ASX-listed Exchange Traded Bonds (XTBs) and Exchange Traded Funds (ETFs).
• XTBs are securities backed by an underlying or specific bond issued by one listed company. The coupon and principal payments from the bond usually flow through to the XTB investor. XTBs are usually tradeable in the same way as shares and offer a known maturity date, coupon amount and payment schedule.
• ETFs provide investors with exposure to a professionally-managed portfolio of sovereign or investment grade bonds and aim to track the performance of a particular bond or index. An ETF is an investment fund that is bought and sold on the stock exchange. Investors can buy or sell units of an ETF using an online broker or through a financial adviser.
• While most ETFs are passively managed with an aim to replicate the performance of an index, ETFs are playing an increasingly expansive role in portfolio construction. In fact, global asset manager State Street Global Advisors recently conducted a survey – “Preparing for the Big Shift” – where it was found that 50 per cent of investors were making significant use of ETFs to construct their core fixed income portfolio allocations, such as government bonds and investment grade credit or corporate bonds.
• And as volatility increases, in 2021 net inflows into actively-managed bond ETFs were the largest on record in the United States, according to Emerging Portfolio Fund Research (EPFR).

Why invest in bonds?

• Bonds can play several key roles in an investment portfolio, providing diversification, stability and income, while potentially acting as a deflation hedge.
  • Steady income stream: Bonds can provide a steady stream of income to investors, with coupon payments made on a quarterly, half-yearly or annual basis. Bonds also have fixed maturity dates when the principal amount or face value is repaid, enabling investors to either spend or reinvest with some certainty.
  • Capital preservation: Bonds can provide capital stability, enabling an investor to preserve capital with the face value returned to the investor at maturity, provided the issuer is creditworthy and doesn’t default.
  • Diversification: Bonds are generally less volatile and uncorrelated with riskier asset classes, reducing overall investor portfolio risk, while providing defensive qualities during sharemarket declines.
  • Deflation hedge: As the rate of inflation falls, bond yields also fall and bond prices rise making them an effective deflation hedge.
• At the same time, investors should also be aware of several key risks when investing in bonds, such as liquidity, interest rate, duration, market, inflation and credit risks.
  • Liquidity risk: The liquidity of some bond or fixed income securities may be lower than other ASX-listed securities, such as shares.
  • Interest rate risk: For fixed income securities that pay a fixed return, there is a possibility that the rate of interest received may not be in line with the market rate at the time. Changes in interest rates and the accrual of interest since the last coupon payment may also impact the price of the fixed income investment. In an environment where interest rates are rising, the bond would lose value in the secondary bond market if sold or mark-to-market on a daily basis like share prices.
  • Duration risk: Similarly, duration risk is the risk that changes in interest rates will either increase or decrease the market value of a fixed income investment. Because payments are typically fixed, if the interest rate changes, then the market value of the investment will change.
  • Credit and default risk: Credit risk is the risk that the bond issuer may not be able to repay the promised return or the principal amount at the maturity date. This is partially reflected by the different rates of interest paid. Should a company declare bankruptcy, bondholders may have a higher claim on company assets than do common shareholders. Importantly, bonds with credit ratings below BBB are of lower quality and considered below investment grade or ‘junk’ bonds.
  • Market risk: If the bondholder sells the bond prior to its maturity through a broker or financial institution in the secondary market, the investor will receive the current market price at the time of the sale. But the selling price could result in a gain or loss on the bond investment depending on the underlying corporation, the coupon interest rate, and the current market interest rate.
  • Inflation risk: Rising rates of inflation typically reduce fixed income investment returns. For example, if fixed-rate debt security pays a 4 per cent return and the inflation rates is 6 per cent, the investor receives a -2 per cent total return in real terms.

Aussie bond allocation – a global outlier

• Australians have a relatively low average allocation to bonds when compared to other OECD countries. In fact, the latest OECD data to 2020, shows that the average bond allocation across all OECD countries is 44.8 per cent, yet Australia’s allocation is just 14.7 per cent.
• Among OECD countries, Australians are actually third from bottom of the pile, above only Poland and Sweden in terms of portfolio allocation to bonds. Every single other OECD country has a more balanced allocation between shares and bonds.
• And data from the Australian Bureau of Statistics (ABS) shows that bonds account for just 3.5 per cent of total consolidated funds under management (FUM) as at June 30, 2022.
• But a new report from BetaShares shows investor demand for fixed income ETFs is increasing, with the ETFs receiving the largest share of industry flows in September 2022 at $322,357,620. The Australian bond ETFs received $285,286,661 of these flows. This easily surpassed Australian equities ETF inflows of $114,216,091 last month. In fact, BetaShares reported that floating-rate Australian bond exposures saw the strongest level of interest in September with ETF investors increasingly cautious about equities as bond yields continue to rise.

Are bonds back in vogue?

• Over the past four decades, developed market government bond yields have fallen sharply. Lower yields have broadly led to much lower levels of bond allocations in investment portfolios, despite strong returns. From 1990 to its peak in January 2021, the Bloomberg Global Aggregate Bond index (unhedged) had delivered an aggregate total return of almost 470 per cent.
• But then came the Covid-19 pandemic in early 2020. In a co-ordinated approach to the health and economic crisis, central banks cut benchmark policy rates to near zero. They also bought trillions of US dollars worth of bonds to anchor borrowing costs a very low levels (that is, ‘Quantitative Easing’) to support businesses and households through lockdowns and a global recession. In 2021, a massive amount of policy stimulus saw a huge rebound in global economic activity, with world gross domestic product (GDP) rebounding by a record 6 per cent, according to the International Monetary Fund (IMF).
• But in 2022 combined monetary and fiscal stimulus, strong consumer demand, supply chain snarls, soaring commodity prices and tight labour markets have all pushed up consumer prices.
• It has been a difficult year for bond market investors, encountering the worst downturn since at least the 1970s, as global central bank policymakers lift interest rates aggressively to combat the highest inflation rates in four decades.
• Heightened geo-political risks and global economic growth concerns have also influenced bond prices. And sparse liquidity and balance sheet ‘normalisation’ by central banks (that is, ‘Quantitative Tightening’) has triggered price dislocation in sovereign debt markets with credit spreads also widening.
• With the US central bank, the US Federal Reserve (‘the Fed’), increasing interest rates by 300 basis points since March 2022 and the Reserve Bank of Australia hiking its cash rate target by 250 basis points since May 2022, both Australian and US government bond yields have soared.
• In fact, the short-end of the yield curve – which is most sensitive to interest rates – has seen the fastest run-up in yields. For example, the 2-year US Treasury yield has lifted almost 400 basis points to a near 15-year high of 4.60 per cent year-to-date to October 21, 2022, before easing back to 4.40 per cent. And in Australia the 3-year AGB has surged almost 290 basis points to around 3.80 per cent over the same time period, though has since eased back to 3.30 per cent.
• Longer-dated 10-year US and Australian government bond yields have both jumped above 4 per cent, up by 270 basis points and 255 basis points, respectively over the period. The US yield is near the highest level since June 2008 with its Aussie counterpart is just below 10-year highs at 3.80 per cent. The US 2s/10s yield curve has inverted, signalling a potential recession.
• With bond prices falling and yields increasing sharply, the Bloomberg Global Aggregate Bond index (unhedged) has declined 23.8 per cent from its record high in early 2021 in US dollar terms. For Aussie investors, the Bloomberg AusBond Composite 0+ Year index has dipped 9.1 per cent since the beginning of 2022 to October 28, 2022 in Aussie dollar terms.

Outlook

• Fears of a global recession are mounting.  Global central banks are aggressively ‘front-loading’ interest rate hikes, core or underlying inflation remains elevated, tensions in the Russia-Ukraine war are intensifying, energy prices are soaring in Europe and China’s property sector remains under pressure.
• In this environment, a global economic slowdown caused by restrictive monetary policy will eventually weigh on consumer demand and business activity, leading to higher unemployment and a weakening of household spending. Housing activity is already waning with home prices declining sharply from recent peaks. With economies slowing, inflationary pressures should eventually ease, enabling central banks to conclude their monetary tightening cycles with a policy ‘pivot’ expected within the next 12 months.
• Within fixed income, there is still some room for bond yields to move higher and prices to fall in the near-term, as central banks continue to hike rates to combat elevated inflation. While negative portfolio returns are unnerving for investors in the short-term it is important to focus on a longer-term investment horizon of three years or more.
• The manager of the fixed income portfolio – which is actively managed – is unlikely to sell the bonds before maturity. And if the bonds don’t default the investor will get their par value principal back. As the current bond market correction continues in the short-term, now is probably not the time to crystallise mark-to-market paper losses.
• In fact, investors should consider the higher yields now on offer in the fixed income asset class, but duration positioning (that is, positioning for interest rate sensitivity) remains critical to preserving capital. Bond prices are expected to eventually stabilise and recover after a period of heightened volatility caused by central bank bond buying programs and rapid moves in interest rates. In fact, Commonwealth Bank (CBA) Group economists expect the Aussie 3-year government bond yield to ease to 3 per cent by June 2023 with the 10-year falling back to 3.5 per cent.
• In our view, developed market government bonds are approaching an ‘equilibrium level’ – near long-term fair value – after several years of being expensive. The sell-off in bonds has cheapened valuations, making fixed income more attractive both in absolute and relative terms, while potentially offering higher income to investors.
• From an Australian perspective, the expected relative outperformance of the domestic economy over the next 12-24 months combined with a shallower rate hiking cycle relative to overseas could mean that the Aussie bond market is considered  a ‘safe haven’ relative to its global peers. While Australia isn’t completely immune from a global recession, outside of the early part of the pandemic it hasn’t recorded two consecutive quarters of economic contraction – the technical definition of recession – for 31 years. If policymakers are able to engineer a ‘soft landing’ for the economy, Aussie corporate bonds could perform quite well.
• As always, investors should consult their financial adviser, who can assess their personal financial circumstances and appetite for risk, before making an investment in the fixed income asset class.