Originally published by UBS Asset Management
Back in mid-2016, we published a white paper, challenging investors and advisors to look beyond the superficial and deepen their thinking about fixed income markets. That paper was published in the immediate aftermath of the UK's decision to leave the European Union, and as the Reserve Bank of Australia took the official cash rate down to a new record low of 1.50%. Since then, a lot has changed. Donald Trump is now President of the United States; the FOMC has raised the Federal Funds rate again (with more hikes planned for 2017); the UK has not slumped into recession (and has not even triggered the process of divorce from the EU); and bond yields have risen considerably across the developed world, particularly at the long end of the yield curve. Mainstream media continues to shout loud and clear that the bond market is not the place to invest, that central banks are retreating, inflation is back, and the golden age of ever-declining bond yields is over. The narrative is pretty much the same as it was this time last year. Also, did I forget to mention the US $3.6 trillion that was wiped off the market capitalization of the Bloomberg Barclays (LON:BARC) Global Aggregate Index from its peak in August 2016 until the end of the year? Pretty shocking stuff for a defensive asset class… only a fool would stick with fixed income now, right?
How about some alternative facts? For the 12 months ended January 2017, the Bloomberg Barclays Global Aggregate Index returned 3.26% to Australian investors, for a global bond allocation. Over the same period, the Bloomberg AusBond Composite Index returned 2.30% for a purely domestic Australian Bond portfolio. Now, these annual returns were well down from their peaks in mid-2016, but they were still positive, in absolute terms, and better than the returns that were provided by Australian cash. Active fund managers, such as UBS, added value for our clients, over and above these benchmark returns. How did we manage to escape the bond market Armageddon that was 2016 with a positive outcome? Wasn't that the supernova that was going to explode one day, or the bond bubble finally being popped?
The answer is so simple as to be, perhaps, embarrassingly obvious: income. That recurrent accumulation and payment of interest income from investment grade bonds more than offset any decline in their capital values over the fourth quarter of 2016. For the Bloomberg Barclays Global Aggregate Index, we estimate that coupon income provided around 2.60% of total return for the 12 months to January, while the income-like benefits from hedging out AUD currency risk delivered another 1.80% of total return to Australian investors. That's 4.40% of return from very stable sources, and ones that are unlikely to change in the near term, as the RBA stays on hold (alongside the ECB and BOJ), while the Fed moves cash rates gradually higher. Against that, the rise in global bond yields, and steepening of yield curves, detracted around -1.00% from total returns for the year to January 2017, while the early prepayment of some bonds cost another -0.15%. As we discussed in last year's white paper, total returns remained protected, and positive, as the stable sources offset the volatile sources.
In addition to this, global bond markets did not move with a beta of 1, and so while the US Aggregate Index rose by 27 basis points in yield over the past 12 months, the corresponding index yields in Europe, the UK, Japan, and Australia barely budged. That diversification also protected the total returns generated by a global bond portfolio, as did active management from your trusty portfolio managers here at UBS. Looking forward, the rise in bond yields that occurred during Q4 of last year now provides an excellent opportunity for that regular stream of coupon income, and new money, to be reinvested at higher interest rates, preserving – if not increasing – the running yield on the portfolio. These market movements are nothing to be feared, as total returns have remained positive on an annual basis, and the stable sources of return have proven their mettle in the heat of battle. The paths for major central banks over 2017 seem fairly clear, and divergences in outlook between the US Fed and the rest of the world will provide us with plenty of investment opportunities.