Inflation on the rise.

Assuming an easing in current global trade war concerns, it still seems likely that global long-term bond yields will rise rather than fall somewhat over the next year or so.

This note examines the likely impact on fixed-income bond returns, and the degree to which the prospect of higher rates can already be “priced” into the market.

Long-term bond yields – a return to normal still some time away

As seen in the chart below, long-term bond yields in Australia have lifted somewhat from the low of mid-2016 – largely due to higher rates in major industrial economies such as the United States, as central banks have started to gradually withdraw policy stimulus. That said, bond yields still remain somewhat lower than the average prior to the global financial crisis, and further gains seem likely especially if the Reserve Bank eventually moves to lift local short-term interest rates also.

How susceptible are fixed-income returns to rising yields?

At face-value, rising bond yields are not great news for holders of fixed-rate bonds. After all, higher market interest rates tend to reduce the market value of fixed rate bonds, because their future stream of fixed nominal interest payments are worth less in today’s dollars.  The key measure of this price sensitivity to interest rates is known as the modified duration, which in turn is related to the remaining term-to-maturity of the bonds in question.

For example, one of the most commonly used bond benchmarks for local fund managers and Australian Bond ETFs is the Bloomberg AusBond Composite Index (BACI).  The BACI is weighted by bonds on issue in the Australian market and as such has around a 90% weight to Government bonds and 10% weight to corporate bonds and an overall modified duration of 5.2 years as at end-May 2018.   This implies that a 1 percentage point increase in the general level of market interest rates that applied to bonds in this Index would overall lower the market value of bonds in the Index by 5.2%.

So far so bad – but there are three countervailing points worth considering.

• To the extent long duration fixed-rate bonds usually offer higher yields than shorter duration bonds and cash, investors are being compensated to a degree for the decline in market values should interest rates rise.  For example, if the BACI offered a 1% higher income return over the coming year than cash, then its annual return would still be better than cash for any lift in bond yields of less than around 20 odd basis points over this period (0.2% times 5.2 modified duration equals a 1.04% loss in capital value).
• The longer it takes for bond yields to rise, the slower the drag on bond values over any given period, and the more likely their yield returns in this period will keep overall returns positive.
• While a lift in bond yields hurts the value of existing bonds held, it does result in higher income returns over time as and when new bonds are purchased that now offer higher yields.

As seen in the chart below, for example, the BACI has experienced periods – typically when bond yields are rising – in which returns under perform that available from cash, as proxied by 1-month bank term deposits*.  But these periods of under performance have tended to be brief, and have been soon recouped from the higher income returns that long-duration bonds tend to offer over term deposits.

The BetaShares Investment Grade Corporate Bond ETF (CRED)

We can take this analysis further by considering returns from the index used in the BetaShares Investment Grade Corporate Bond ETF (ASX Code: CRED). Compared to the BACI, the Index which CRED aims to track provides exposure to bonds which are generally longer in duration and only from the corporate sector (i.e. it excludes lower-yielding government bonds). As a result, CRED’s Index should typically offer a higher yield than that available on the BACI, albeit with greater price sensitivity to changes in the general level of interest rates and corporate credit spreads over time. Indeed, the modified duration for CRED’s Index as at end-May 2018 was 6.5 years.  CRED’s Index yield-to-maturity as at end-May was 4% p.a. compared to only 2.6% p.a. for the BACI.

How have these generally higher income returns but greater price sensitivity to market conditions affected the relative returns of CRED’s Index over time?  As seen in the chart below, the returns of CRED’s Index have generally been stronger than that of the BACI since early 2008, which can be partly attributable to the trend decline in bond yields over this period.  That said, even in the period of relatively steady bond yields over the past year or so, CRED’s Index has still outperformed the BACI, due to the generally higher yield it offers.

Note, moreover, that while there have been periods in which CRED’s Index has under performed the BACI, such periods have tended to be relatively brief and quickly recouped from the relatively higher yields offered by bonds in CRED’s Index.

All up, while bond price returns will tend to be reduced as and when bond yield rise, overall returns will be supported to some extent by the generally higher income they offer – especially compared to more capital stable assets such as cash. From a longer-term perspective, moreover, higher bond yields are good news for investors in long-dated fixed-rate bonds as income returns will tend to increase over time.

These features are even more evident when higher yielding fixed-rate bond exposures such as the CRED ETF are considered. Over time, CRED’s Index has historically outperformed the commonly used AusBond Composite Index with only relatively brief periods of under performance when bond yield have risen and/or credit spreads have widened.

* Monthly term deposits rates sourced from the Reserve Bank of Australia, which is based on the average rate offered by Australia’s 5 largest banks.

By David Bassanese

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David Bassanese

Australian investor portfolios currently have a relatively low exposure and therefore limited potential to take advantage of the growing agricultural sector, according to a whitepaper by BetaShares, a leading manager of exchange-traded funds.

BetaShares research found that the benchmark S&P/ASX 200 Index has significantly less than 1% exposure to agricultural companies. However, agriculture is a key global sector with the potential to enjoy solid long-term growth as the quantity of food demanded worldwide increases.

“The growth of the global population means the agriculture sector has compelling long-term growth potential as there are increasingly more mouths to feed. In addition, unusually extended periods of good global growing conditions have pushed many agricultural commodities prices to relatively low levels too, meaning the outlook over the short-term has good upside price potential should conditions change,” said BetaShares Chief Economist David Bassanese.

For example, after slowing from a 3% annual growth pace in the 1960s to a low of 1% in the late 1990s, growth in global grain consumption returned to a near 2% annual growth rate over the past decade largely due to rising demand from emerging economies.

“While agricultural prices tend to be volatile from year to year – reflecting the impact of weather on supply conditions – there is a clear underlying trend for growth and agricultural investments can play an important role in a diversified portfolio.”

“To invest in agriculture, investors can directly own grain, livestock or even farms, however these methods are not practical for most investors. Another option is to gain exposure through commodity price futures – though this is a sophisticated investment strategy not typically accessible to the majority of investors,” added Mr Bassanese.

“Exchange traded funds are a simple, cost-effective way for Australian investors to gain transparent and diversified exposure to agricultural commodities or agriculture companies.”

BetaShares currently offers two options for investors looking to access the agricultural sector:

• the BetaShares Agriculture ETF – Currency Hedged (synthetic) (ASX: QAG) enables investors to gain exposure to the $US performance of a basket of agricultural commodities
• the BetaShares Global Agriculture Companies ETF – Currency Hedged (ASX: FOOD) gives investors exposure to some of the world’s leading agricultural companies outside of Australia.

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David Bassanese

Anticipation of an increase in US interest rates in 2015 drove a rise in the US dollar, falling commodities prices and a sustained sell-off in the Australian equities market during the month of September, according to BetaShares’ Global Market Review.

The review, which analyses performance across seven major asset classes, found that international equities was the best performer for the month, experiencing 3.7% growth as increased confidence in the economy drove the US share market higher. The price of international equities in real terms also increased as the Australian dollar headed towards a four-year low against the US dollar.

US dollar strength was a major theme in global markets in September, with the greenback rising 6.8% against the Australian dollar over the month. Continued weakness in iron ore prices was also a major contributing factor to the weak AUD, said BetaShares Chief Economist David Bassanese.

“The fear of an end to quantitative easing hurt commodities and commodity exporting equity markets such as Australia’s – and emerging markets like Brazil – particularly hard,” Mr Bassanese said. “The strength of the US dollar added another negative factor to increasing commodity supplies and only modest global growth, making it hard to be positive on the commodity price outlook.”

Australian bonds and listed property also fell over the month, as the sell-off in the local equities market suppressed any increase in bond yields as a result of anticipated Fed tightening. Low global inflation and geopolitical tensions were likely to drive a further fall in yields by the end of the year, which could also affect the property sector, said Mr Bassanese.

“Unless the RBA moves to an easing policy bias again, 10-year bond yields are likely to head back to 4% p.a. by year end,” Mr Bassanese said. “While property is holding up well thanks to the uplift in residential construction and high land values, it could also be at risk of underperformance once the increase in bond yields begins.”

Looking ahead, Mr Bassanese noted an expectation of further international equities outperformance, with the Australian dollar moving down to 85 cents by the end of the year. “Given falling commodity prices and the AUD’s still uncomfortably high real level, I would expect medium-term weakness against the US dollar, the Euro and the Pound,” he said.

“This should drive global equities outperformance against the Australian market in unhedged terms, with the current pullback in global equities likely only a correction in a broader bull market.”

Click here for a copy of the full Global Market Review is attached.

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David Bassanese

BetaShares, a leading provider of Australian exchange traded products, announced yesterday the appointment of David Bassanese as Chief Economist. In the newly formed role, Mr Bassanese will be responsible for developing economic insights and portfolio construction strategies for adviser and retail clients.

Mr Bassanese has an accomplished background in financial services spanning over 25 years, with his most recent role being an economic columnist for The Australian Financial Review (AFR) for over a decade. His regular “Bassanese Column” was published three times per week and looked at local and international economic trends, equity markets, interest rates, exchange rates and commodities.

Prior to the AFR, Mr Bassanese spent several years in the financial markets as a senior economist and interest rate strategist at Bankers Trust and Macquarie Bank. He started his career as a Commonwealth Treasury official, after which he spent three years as a research economist at the Organisation for Economic Cooperation and Development (OECD) in Paris, France.

Alex Vynokur, Managing Director of BetaShares said: “We are excited to have someone of David’s calibre join BetaShares in this newly formed role. As a leading Australian manager of exchange traded products, we are committed to enhancing investor education, and David’s appointment is a significant milestone in that regard,” he said.

Mr Bassanese is the author of two online investment books, including Australia’s most comprehensive book on the local ETF market.  He graduated with first class honours from the University of Adelaide, and a Master in Public Policy from the J.F. Kennedy School of Government at Harvard University.

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David Bassanese

Leading financial analyst, David Bassanese, believes many Australian investors could revolutionise their portfolios – slashing costs and increasing simplicity – by discovering one of the best kept secrets in the financial industry, exchange traded funds or ETFs.

“ETFs are simply listed indexed funds, enabling investors to buy exposure to the overall Australian or international equity market, industry sectors, bonds or even gold – just as they would with company shares,” explains David, “however many investors haven’t heard about them as due to their low management fees and lack of product commissions, financial planners and superannuation funds have been slow to embrace them.”

Around 70,000 Australians now own ETFs, and the market capitalisation of ETF-type products has grown strongly in recent years – by 50% last financial year alone – to $7.7 billion.  Yet despite their advantages, still only 7 per cent of the 480,000 self-managed super funds use ETFs, and only 1 per cent of the 6.7 million investors that own shares more broadly.  ETFs account for a mere 0.4% of the $2 trillion funds management industry.

To redress this information gap, David is set to launch Australia’s first comprehensive independent book at the Australian Securities Exchange next week on the local ETF industry, titled The Australian Investor’s Guide to Exchange Traded Funds (ETFs). David’s book reviews the almost 90 ETF-type products now available on the Australian market, and offers ETF trading and investment tips.  The book includes examples of highly diversified model portfolios, with effective management fees up to 10 times less expensive than many actively managed retail funds.

With the looming abolition of financial planning production commissions, the growing role of SMSFs, and widespread evidence that few active managed funds consistently beat index funds, David believes ETFs could be poised to revolutionise Australia’s financial system.

David’s publishing strategy is also revolutionary. Eschewing traditional “bricks and mortar” retail distribution, the book is being sold as a downloadable e-book only, and only from his website. This will enable the book to be updated far more regularly, as the local ETF industry evolves.

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