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Written by Ivan Fletcher – Senior Adviser
Before we look at what this means for investors, it is important to understand how bonds work, in particular that yields move inversely to price.
How Bonds Work
If the government issues a bond (which is basically a fixed amount of debt with a fixed interest payment) for $100 and agrees to pay $3 a year in interest, this means an initial yield of 3%. If growth and/or inflation slows and the central bank cuts interest rates, investors might snap up the bonds paying $3 till the yield is pushed down to say 2%. In the process, the value of the bond goes up giving a capital gain. This is what’s happened over the last 40 years. But as growth or inflation pick up and bond yields rise, investors suffer a capital loss. We have started to see evidence of this over the last 12 months with negative returns on long term bonds (both domestic and global). This is a perfect example of why past performance is no indication of future performance.
Most of us are familiar with the look of long term share market charts – consistently sloping up over the long term, but with plenty of pot holes or temporary dips along the way – but are you familiar with charts for bonds? Like currency movement, interest rates ultimately have what I call tidal behaviour – where they have a high and low watermark at which point they then retreat or reverse direction. You might recall the AUD/USD in 2012 (post GFC) made it to about $1.10 USD before it began its big reversal and with the global outbreak of COVID hit the bottom end just under $0.60 in March 2020 which saw the tide move from high to low in about 8 years.
For Bond yields it has been a much longer journey from top to bottom – taking 40 years after taking 40 years to get from bottom to top with both being described as ‘Super Cycles’.
While there have been numerous premature calls over the years that the super cycle bull market in bonds is over (myself included) its looking increasingly likely that this time for a bunch of economic and political reasons it may actually be over.
• Major central banks are now more aggressive in seeking to boost inflation.
• Governments have had a massive shift in fiscal stimulus swinging from fiscal austerity on the back of the GFC to increasing money supply to boost spending and hence inflation on the back of the pandemic.
• We are seeing a decline in workers relative to consumers as populations age which means more constrained labour supply and greater worker bargaining power (i.e. wage inflation).
• A decline in new coronavirus cases globally has led optimism that reopening globally will be sustained with Global inflation continuing to rise (supported by surge in energy prices)
A Slow and steady rise in yields
The shift to a rising trend is expected to be gradual with periodic spikes and then setbacks as we have seen this year. Some of the reasons for this are :
• In contrast to the 1970s inflation expectations are much lower.
• High private debt levels mean that rate hikes will be more potent than they used to be – so central banks like the RBA won’t have to raise rates as much to control inflation.
• High public debt levels may see some central banks under political pressure to limit the rise in bond yields and hence public debt interest costs.
So what does this mean for Fixed Interest Investments ?
With rising yields, investment returns in this sector will be adversely effected including negative returns where capital losses are greater than the yield (which we have seen in recent times).
So What are the Alternatives for Defensive Investments ?
During the decades of falling interest rates, fixed interest bonds have produced Capital Gains on top of Coupon Interest. With Long term rates now more likely to be rising the alternative for defensive investments is to diversify this exposure into alternative interest bearing product including funds with a focus on shorter dated bonds and variable interest rate exposures which are likely to be less adversely impacted by interest rate rises in long term fixed interest bonds.
Implications for Other Investment Classes
- Shares will become more expensive, however this is more of an issue in the event of a sudden or sharp rise in yields as opposed to a gradual rise.
- The margin above bond yields on Real assets like commercial property and infrastructure will reduce.
- rising bond yields are pushing up fixed mortgage rates again in Australia and this along with poor affordability and higher required debt interest rate buffers will drive a further slowing in residential property price gains into next year.
Source : Shane Oliver (AMP Capital)