A common misconception in recent investment commentaries is that fixed income investors are sure to suffer losses if interest rates rise. The evidence shows that this is not necessarily so.
Many commentators fear the initial price impact on bond markets of a sharp interest rate rise, but factors such as the velocity of interest rate change, reinvesting in higher bond coupons, the impact of credit spreads and “roll-down” tend to mitigate the capital drawdown, over time.
A period of rising interest rates does represent a more challenging period for Australian fixed income markets but the reality of a rising interest rate environment on the back of improving economic conditions is a far cry from the doomsday expectations of some.
Since the 1980s there have been four bear markets in the local fixed income market, where interest rates have increased by 2 per cent or more; April 1988 to February 1989; January 1993 to January 1994; October 1998 to January 2000; and February 2009 to August 2009.
The Legg Mason Western Asset Australian Bond trust generated a positive total return in three of those four bear markets.
Since the last of those bear markets, we have seen a dramatic fall in the level of domestic interest rates. The 10-year government bond yield has fallen from around 6 per cent to 2 per cent over that period.
A decline in yields equates to an increase in the capital value of bonds, on top of coupons. Bond values rise because investors are prepared to pay a higher price for a security with a coupon that is above the prevailing market yield.
Correspondingly, when interest rates rise the capital value of bonds falls.
This multi-year rally in bonds has led to concerns that there will a crash for bond investors if bond yields return to their long-term average.
This is an over-simplified scenario, based solely on the impact of duration on bond prices. It fails to take account of other factors.
The first thing to consider is that as interest rates rise, reinvesting at higher coupons will offset mark-to-market losses from rate rises through time.
Further, the generally positive slope of the yield curve results in a portfolio of bonds generating capital appreciation through time, simply by moving closer to maturity and rolling down the curve.
To give an example of this roll-down effect, if an investor buys a five-year bond with a yield of 2.4 per cent and holds it for one year, the term risk attributed to the bond is deemed to be lower and therefore the yield required for an investor falls to 2.3 per cent.
This change in yield has a positive price impact, as the bond’s market price increases from its initial issue price of 100 to 100.38, all else being equal. If at this point the investors sells the bond, their total return would be the 2.4 per cent coupon and the 0.38 per cent capital return.
When interest rates move, the impact on bond maturities is rarely perfectly linear. Some maturities may depreciate significantly, while others may remain flat and others appreciate in value.
It is also important to recognise that the velocity of a rise in interest rates is just as important as the destination. A protracted grind higher over an extended period has less of an impact on the total return of a bond portfolio than a sudden change, as there is more time for coupons and reinvestment proceeds to help compensate the investor.
Skilled active fixed income managers can lower portfolio duration in the face of rising rates and adjust the portfolio’s exposure to other risk factors. They can employ inflation-linked securities and derivatives to implement conditional strategies to mitigate mark-to-market movements.
The fundamental structure of a portfolio of bonds is to be regularly reinvesting as it receives coupons and bonds mature. Over the medium to long term, reinvesting at higher rates will improve total return.
Managers can include corporate bonds in their portfolio. These offer credit spreads over government bonds – interest rate margins above the government bond rate. These yields typically decline during periods of rising rates, providing an offsetting price appreciation.
Investors in Australia retain one of the lowest allocations to the fixed income asset class in the developed world.
While this is concerning in itself, what is more concerning is that the replacements for fixed income are cash and term deposits, which have over time produced lower returns and not offered the diversification benefits of fixed income. Australian fixed income has outperformed cash over the past decade.
In five of the six most recent equity market selloffs, Australian bonds have provided strong positive returns to help dampen total portfolio volatility. The negative correlation of equites and bonds is a fundamental element of portfolio diversification.
Cash and term deposits can play an important role in an investor’s overall asset base, depending on their circumstances. However, their characteristics are very different from fixed income and they are not a sound replacement in a properly diversified portfolio.
Jonathan Baird is an investment specialist at Western Asset
