If you’re feeling a little unnerved about your bond portfolio at the moment, you are likely not alone.
The new normal of low interest rates, unconventional monetary policy, and modest growth have many investors scratching their heads. Particularly of late as bond yields have risen both here and in the US, which is typically a signal for market volatility and capital losses.
In Australia, uncertainty around future monetary policy has sparked higher volatility in bond prices. There is some speculation over whether the latest easing cycle has ended, will continue, or pause. In the US, the prospect of fiscal stimulus has driven bond yields higher with investors fearing future inflation—the bogey of fixed income investors.
The fears of future inflation and higher bond yields are likely overdone, however. Rates are unlikely to increase back to the yields we experienced prior to the Global Financial Crisis. The secular trends that have shaped the world’s economies over the last few decades—technology, demographics, and globalisation—will continue to restrict growth, inflation and interest rates.
For example, technology has reduced business demands for capital as companies—for example, Uber, AirBNB, and Amazon—become less capital intensive pushing the price of capital—that is, interest rates—structurally lower.
Favourable demographics—think Baby Boomers—gave economic growth a boost over the last few decades. But now, as the Boomers retire, the tailwind for growth is fading.
Additionally, globalisation has given us access to low-cost manufacturing, which in turn has resulted in lower prices and disinflation.
These three trends will restrain inflation, growth and interest rates for the foreseeable future.
All this puts the outlook for bond returns at about 1 to 3 per cent per annum, on average, over the next ten years. Certainly much lower than the heady days of high yields pre-GFC, but not too bad in the context of persistent low inflation.
Don’t fear the bond bogey
Yet many investors fear higher interest rates. And, given the inverse relationship between bond yields and bond prices, higher interest rates can result in losses on bond portfolios as lower yields on older issues suddenly look less appealing.
Commentators often extend this argument—erroneously—by saying that yield increases are bad for investors. However, higher bond yields are typically good for long-term investors.
In fact, long-term bond investors should be cheering for higher yields.
When interest rates rise, bonds experience capital losses. Some of us remember 1994 when the RBA raised rates from 4.75 per cent to 7.5 per cent in four months. This caused carnage in bonds with the index down over seven per cent at its worst point during 1994. Not exactly cause for celebration.
But let’s skip forward five years to 1999 and see how bond investors fared after these rate increases. From the start of 1994 to the start of 1999, the Bloomberg AusBond Composite index saw an average annual return of over nine per cent per year. This healthy return includes the 4.5 per cent lost during calendar year 1994. While rate hikes caused short-term pain, they also resulted in long-term gains.
It all adds up
Why is this so?
Interest rate moves affect bond returns in two opposing ways. The primary mechanism is through capital gains or losses arising from changes in interest rates. When rates increases, bond prices immediately fall—the extent of the move will vary depending on the interest rate sensitivity, or duration, of the bond. However, there is a secondary impact that is more enduring but less severe—reinvestment risk.
When interest rates increase, reinvestment risk works in favour of bond holders who reinvest their bond cash flows. Rate increases cause bond holders to effectively receive higher returns over the future holding period of their bonds. At first this effect is small—adding marginally to returns.
However, over time, these marginal gains add up. And, over time, they will eventually more than make up for the initial impact of rate changes on capital values, provided cash flows are reinvested.
For long-term investors, reinvestment risk is the more important effect, and one that should be kept front of mind during periods of bond market volatility.
Think big for bond exposure
Investors looking to introduce a bond exposure into their portfolio can use a number of vehicles. A good starting point is through a diversified exposure to a range of bonds—ideally a fund that spreads risk across bond maturities, debt issuers and sectors. A broadly diversified portfolio will reduce the risk that particular issuers or sectors dominate portfolio returns.
Diversification can be further enhanced through international holdings. When considering international bonds, most experts would recommend currency hedging the portfolio to remove the risk that changes in the value of the Aussie dollar will affect the portfolio’s value. Today, investors have a range of funds which offer diversified local or global bond exposure—via exchange-traded funds (ETFs) or managed funds.
International fixed income ETFs are the latest tool investors can use to tap this exposure, having first come onto the Australian market in late 2015. Over the 2016 calendar year, this ETF category attracted $168 million in new money, with investor appetite for broad exposure to global debt anticipated to continue.
Despite concerns about the potential for rates to head up over the coming years, long-term investors should not rule out including bonds in their portfolio. While future rate increases can result in short-term losses, over time higher reinvestment rates slowly but surely make up for these losses and contribute to higher future portfolio returns.
While we don’t expect every bond investor to party like it is 1999 when rates rise, at the very least they shouldn’t panic like it is 1994.
