Bonds Behaving Badly?
David Bassanese | Sep 13, 2017 14:44
Originally published by BetaShares
Although the Reserve Bank of Australia has kept official short-term interest rates steady since August last year, it may surprise some investors to know that returns from Australia’s traditional fixed-income asset class – comprised largely of Australian government bonds – have been negative over this period. By contrast, returns from a narrower index of corporate bonds, and especially floating-rate bonds, have been far better. These results highlight the fact that supposedly relatively “safe” investments are not always as reliable as some investors may imagine.
h2 Steady cash, higher government bond yields but narrowing credit spreads/h2The past year has witnessed some divergent trends in the Australian cash and bond markets. As seen in the charts below, although the RBA left the official short-term cash rate on hold, the yield on Australian fixed-rate government bonds tended to rise – which in turn reflected reduced market expectations of further monetary policy easing in Australia and higher US bond yields.
By contrast, as seen in the charts below, continued good growth in the global (and to some extent Australian) economy – and the fact that the overall level of global interest rates still remained relatively low – led to further downward pressure on corporate credit spreads over the past year, as investors continued to search for yield. The combination of higher government bond yields but narrower credit spreads led to a smaller net increase in corporate fixed-income bond yields.
As we have previously discussed, due to the fixed nominal income payments offered by fixed-rate bonds, higher market yields must be reflected in lower market prices for such bonds – resulting in potential for negative capital returns whenever yields rise. What’s more, the sensitivity of fixed-rate bond prices to changes in interest rates, increases with the bond’s term to maturity.
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Due to their fixed-rate nature and relatively long duration, therefore, it should be no surprise that the larger rise in government bond yields over the past year hurt returns from government bonds the most. Indeed, the Bloomberg Treasury Bond Index (comprised only of Australian Government bonds), produced a negative 2% return over the twelve months to end-August 2017.
So much for the “safety” of government bonds!
Source: Bloomberg. * Solactive Australian Bank Senior FRB Index. You cannot invest directly in an Index, and total return figures shown do not include QPON’s fees and expenses. Inception date of QPON’s Index is 30 May 2017 and data prior to this date has been simulated and may not be reflective of actual results. Past performance whether simulated or actual is not indicative of future performance.
Because the yield on fixed-rate corporate bonds rose by less than for government bonds – and also because corporate fixed-rate bonds tend to be of shorter duration (hence are less sensitive to market interest rate changes), the capital loss over the year on the Bloomberg Corporate Bond Index was less than that for the Treasury Index, allowing the former to produce a better total return of 2.2%.
All up, reflecting the combination of returns from both government and corporate fixed-rate bonds, the Bloomberg AusBond Composite Bond Index (BACI) – the benchmark measure of Australian fixed-rate returns – produced a negative return of 0.66% over this period.
h2 Less sensitivity to rising rates and narrower credit spreads helped floating rate bonds (FRBs) shine/h2Floating-rate bonds (FRBs) have over the past year enjoyed stronger returns than both government and corporate fixed-rate bonds. Indeed the Solactive Australian Bank Senior FRB Index returned 3.8% over the twelve months to end-August 2017.
How so? As we have previously explained, the capital value of FRBs is less sensitive to loss (gain) arising from a higher (lower) level of general interest rates – because a key component of their regular nominal interest payment adjusts to the prevailing level of rates*. Indeed, higher interest rates – and specifically higher short-term interest rates – results in a lift in nominal income returns from FRBs, and vice versa. That should be somewhat reassuring for investors given that interest rates locally remain quite low and seem likely to rise if we start to look ahead.
What’s more, because FRBs also offer an additional fixed nominal interest rate payment (set by credit spreads at their date of issuance), their capital value over the past year was positively influenced by a decline in market-determined credit spreads*. Accordingly, QPON’s Index produced a total return of almost 4%, somewhat higher than the starting yield of around 2.7%.
*To be specific, in the case of senior bank FRBs in which the QPON ETF invests, payments are partly variable and partly fixed. The variable component of their quarterly interest payment is based on the prevailing market-determined interest rate at which banks agree to lend each other funds over the following 30-day time period (known as the 30-day bank bill swap rate, or BBSW). In addition, these bonds also pay a fixed interest-rate margin over BBSW that is fixed at the date of bond issue and reflects the bond’s maturity and the prevailing market assessed “credit risk” associated with each issuer bank.
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