Here's One Way To Offset The Downturn
David Bassanese | Dec 21, 2018 14:15
Originally published by BetaShares
The current equity market slump, including ‘Shocktober”, has once again shown the value that bonds can play in investors’ portfolios in terms of offering some downside protection. While this may be obvious to some, what is perhaps less obvious is that compared to the traditional benchmark bond indices which are generally heavily weighted to low-yielding government bonds, some longer-duration and higher yielding corporate bond exposures have historically managed to offer even better protective benefits in these periods, whilst still offering greater income returns over time.
h2 Fixed-Rate Bonds: The benefits of negative correlation with equities/h2One of the attractive features of owning fixed-rate bonds is that they generally tend to do best when equity markets are doing poorly, i.e. the returns of these two major asset classes tend to be negatively correlated. The reason is that, as seen in the chart below, equity markets tend to be weak when the economy and corporate earnings are weak, which also tend to be periods when interest rates decline – due to reduced demand for credit and interest rates cuts from central banks. Declining interest rates, in turn, tend to boost the market value of fixed-rate bonds because the future stream of constant nominal income payments they offer are worth more in today’s dollars. The longer the term-to-maturity or “duration” of a bond, moreover, the greater its future stream of income payments, and hence the greater sensitivity of its market price to interest rate changes.
Indeed, as seen in the chart below, the Bloomberg AusBond Composite Index (BACI) – one of Australia’s most widely followed benchmark bond indices – has produced positive returns during each of the recent periods of equity market decline. The BACI is weighted by bond issuance in the Australian market, and accordingly tends to be heavily weighted to Government bonds. As at end-October 2018, the BACI had 90% exposure to government or government related bonds, an overall “duration” of 5.2 years and offered a yield-to-maturity of 2.5%.
Get The App
Due to their higher risk of default, corporate bonds – issued by some of Australia’s leading companies – tend to offer higher yields and income returns than Government bonds over time. Reflecting these risks, as seen in the chart below, the yields on government bonds tend to fall relative to those of corporate bonds (for a given duration) during equity market downturns, i.e. “credit spreads” widen. Indeed, interest rates on some higher risk corporate bonds can even increase during equity market downturns if widening credit spreads more than outweigh a broader decline in market interest rates.
That said, as seen in the chart below, the Index of reasonably high quality long-duration Australian corporate bonds has nonetheless demonstrated a capacity to not only hold up well in value during recent equity market downturns, but even often outperformed the returns from the widely followed BACI.
In fact, the Index of corporate bonds which the CRED ETF aims to track produced returns of 18.8% during the depths of the global financial crisis, outperforming the 14.3% return from the BACI. CRED’s Index also modestly outperformed during the downturns of 2011, 2015-16 and has produced a similar return during the more recent equity downturn in recent months.
h2 Why has CRED’s Index performed well compared to the BACI in equity market downturns, despite widening credit spreads?/h2For starters, CRED’s Index returns get a head start from its generally higher income offering over time – as a reward for taking on extra duration and credit risk. Since February 2008, for example, CRED’s Index has averaged a yield-to-maturity of 5.0% p.a. compared to only 3.9% p.a. for the BACI. The current yield-to-maturity for CRED’s Index is 4.0%, compared to only 2.5% for the BACI. We can add to this higher “roll return”*, which is presently estimated at around 0.9% p.a. for CRED’s Index, compared to only 0.5% p.a. for the BACI. All up, that suggests CRED’s Index is currently offering a prospective one-year income return (all else constant) or around 4.9% p.a., compared with 3.0% p.a. for the BACI – or 1.9% p.a. more!
What’s more, CRED’s Index specifically targets relatively long duration bonds whose capital value, as noted above, should benefit most from the decline in interest rates typically associated with equity market downturns. As at end-October 2018, for example, CRED’s Index had an average duration of 6.3 years, or just over one year longer than the BACI Index.
The potential negative impact of widening credit spreads, moreover, is sought to be limited by the fact that only corporate bonds meeting minimum liquidity and credit rating hurdles can be included in CRED’s Index. All bonds must have a minimum investment grade credit rating and have at least $250m issuance outstanding.
h2 BACI’s duration and credit exposure can vary/h2Note also that, unlike CRED’s Index – which specifically targets only corporate bonds of minimum credit rating and term-to-maturity – the duration and credit exposure (and hence performance over cycles) of the BACI can vary over time depending on the nature of issuance by Government and corporate entities.
Over the past decade, for example, the increased bond issuance by the Federal Government has increased both the average duration and government weight of bonds in the BACI index. Should the Federal Government return to a budget surplus and start reducing its stock of bonds on issue, the composition and behaviour of the BACI over economic cycles will also start to change.
Trading in financial instruments and/or cryptocurrencies involves high risks including the risk of losing some, or all, of your investment amount, and may not be suitable for all investors. Prices of cryptocurrencies are extremely volatile and may be affected by external factors such as financial, regulatory or political events. Trading on margin increases the financial risks.
Before deciding to trade in financial instrument or cryptocurrencies you should be fully informed of the risks and costs associated with trading the financial markets, carefully consider your investment objectives, level of experience, and risk appetite, and seek professional advice where needed.
Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. The data and prices on the website are not necessarily provided by any market or exchange, but may be provided by market makers, and so prices may not be accurate and may differ from the actual price at any given market, meaning prices are indicative and not appropriate for trading purposes. Fusion Media and any provider of the data contained in this website will not accept liability for any loss or damage as a result of your trading, or your reliance on the information contained within this website.
It is prohibited to use, store, reproduce, display, modify, transmit or distribute the data contained in this website without the explicit prior written permission of Fusion Media and/or the data provider. All intellectual property rights are reserved by the providers and/or the exchange providing the data contained in this website.
Fusion Media may be compensated by the advertisers that appear on the website, based on your interaction with the advertisements or advertisers.