Putting The Income Back Into Fixed Income
UBS | Feb 21, 2017 13:45
Originally published by UBS
A couple of weeks ago, we commented on developments in global fixed income returns since Brexit and the Trump revolution. We illustrated that total returns from global fixed income, to Australian investors, had remained positive for the entire year, notwithstanding the rise in global bond yields over the fourth quarter. These returns were also better than Australian cash over the same period. In that update, we also demonstrated that interest income was a strong contributor to delivering these outcomes, and that the interest income provided from global bonds was more than sufficient to offset the -1% drag on capital values from higher bond yields.
Today, we provide a similar update on Australian bonds, using the same framework. Against an average official cash rate of 1.69% for the 12 months to January 2017, Australian fixed income performed relatively well: the Bloomberg AusBond Composite Index 0+ Yrs returned 2.30%, and the Bloomberg Barclays (LON:BARC) Australian Aggregate Index returned 2.21%. These two indices have correlated very strongly in recent years, with the duration differences diminishing over time. When we look into the sources of return for the Bloomberg Barclays Australian Aggregate Index, we find that income provided over 4% of the total return, while a fall in bond prices detracted around 1.8% (see Chart 1).
How did we manage to provide investors with a 4% income return when the cash rate has averaged just 1.69%? The answer lies in the past, with the higher interest rates of yester-year still being paid on the outstanding stock of government and corporate debt. While market yields have fallen sharply in recent years, the average fixed-rate coupon on the entire stock of bonds in the Bloomberg indices has not fallen as quickly (see Chart 2).
It takes time for the high-coupon bonds to mature and then be re-issued with lower coupons, and this delay in market re-pricing has held up the average coupon rate within the Australian market. While the overall yield to maturity is around 2.50%, the average coupon rate within the index is still above 4.25%. As long as there are no defaults, investors will be paid that 4.25% of income from the current stock of Australian bonds, and this coupon stream will cushion total returns within Australian fixed income from further rises in bond yields.
As shown above in Chart 1, rolling annual returns have not been negative over the past 10 years, and coupon income has shielded total returns during periods when the RBA was tightening monetary policy. Even during the so-called taper tantrum of 2013, when bond yields rose independently of any policy changes from central banks, total returns in Australia remained positive, as coupon income cushioned bond price declines.
With the RBA firmly on hold for much of 2017, we expect that on-going accumulation of coupon income greater than 4% will continue to provide support to bond market returns in Australia. It's high time that we recognise this defensive characteristic, and remember to think more about that regular income stream when we talk about fixed income markets.
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