We’ve had a few questions regarding our recent decision to add to our holdings in Australian bonds. The common perception is that, with interest rates still around historic lows, bonds offer a poor return. What’s more, with interest rates on the floor it would seem the only way is up. A bond’s price moves in the opposite direction to its yield (or its “interest rate”). This would mean then, that as well as the poor yield, the bond investor appears to also be putting themselves in front of the proverbial freight train and risking a capital loss for their troubles.

We allocated an additional 5% to Australian bonds from cash across the ClearView funds and models late last year. Given the above, why did we do that? Our reasoning is as follows.

Despite the Reserve Bank of Australia (RBA) cutting the target cash rate by 0.5% last year to 2.5%, yields on Australian bonds actually moved in the opposite direction and increased over the full year, leading to bond investors experiencing modest capital losses. The total return to bonds over 2013 as measured by the benchmark UBS Composite Bond Index was 2% representing an income gain of around 5% and capital loss of around 3%.

Ten year Australian Government Bonds moved from 3.04% in February last year to 4.43% in June. Longer dated bonds (like the ten year), reacted to the US Federal Reserve’s indication that it was going to start turning off the tap and taper down its Quantitative Easing (QE) program of bond buying. Bond markets around the world pushed yields up as they factored in a normalisation of interest rates in the absence of the Fed pinning rates to the floor.

To us, after this move the higher yields available in bonds when compared to cash rates, 4.43% vs. cash at 2-3% began to look interesting. What about the risk of rates going even higher? If we are too early and bond yields have further to rise, this move to add to bonds in November may seem premature.

To get a handle on the risk/return trade off here, we’ll have to introduce a bit of jargon. In the world of bonds, the term “duration” is very important. The easiest way of thinking about this is that duration measures the sensitivity of a bond’s price to changes in interest rates. A bond with duration of 5 will see its price decrease by 5% for every 1% increase in interest rates. Conversely a 1% fall in interest rates would see the bond’s price increase by 5%.

The index for Australian bonds, the UBS Composite Bond Index, has duration of around 4 and gives you a regular payment in coupons of around 5ish percent. If interest rates were to go up by 1% an Australian bond investor would receive a yield of around 5% but incur a capital loss of 1% x 4 = 4% (and remember this is on paper, the capital loss is not actually incurred if the investor holds the bond to maturity); giving them a net return of 1%. Conversely, if interest rates were to go down by 1%, our Australian bond investor would still get their steady coupon payments of 5%, but would also enjoy a capital gain of 1% x 4 = 4%; giving them a net return of 9%.

This seems a reasonable risk/return trade off to us. The RBA has made fairly clear that they see a period of interest rate stability for the next little while. Fed QE tapering would seem to be in the price. The Australian Government ten year bond has retraced back to 4.18%. It seems likely then, that the net return to the Australian bond investor (in the absence of any major positive or negative developments) is just what they receive in regular coupon payments: around 5%.

Our own view is that after enjoying strong macro tail winds, the Australian economy will increasingly be attempting to run into a head wind as Chinese demand for our key exports wanes and the capex phase of the mining boom passes. In such an environment it would be hard to see the RBA raising rates. The central bank would be more likely to be reverting to an easing bias in order to support the economy. Under such circumstances bond yields may fall slightly, giving us the potential for a small capital gain on top of the running yield.

The other reason to hold bonds is as a portfolio diversification tool. There are still plenty of risks out there and equity market valuations, particularly in the US, look pretty full. By having an allocation to bonds the investor builds some shock absorption into portfolios.

Finally, why is it we hold Australian bonds and not international? The reason is the risk/return trade off is more favourable. International bonds have a longer duration that Australian bonds, and in our view are more at risk of further increases in yields leading to capital losses.

Justin McLaughlin, Chief Investment Officer

Hamish Bell, Senior Research Analyst

 

 

 

The information contained in this document is current as at date of publication unless otherwise specified and is provided by ClearView Financial Advice Pty Ltd ABN 89 133 593 012, AFSL 331367 (ClearView). Any advice contained in this material is general advice only and has been prepared without taking account of any person’s objectives, financial situation or needs. Before acting on any such information, a person should consider its appropriateness, having regard to their objectives, financial situation and needs. In preparing this presentation, ClearView has relied on publicly available information and sources believed to be reliable. Except as otherwise stated, the information has not been independently verified by ClearView. While due care and attention has been exercised in the preparation of the presentation, ClearView gives no representation, warranty (express or implied) as to the accuracy, completeness or reliability of the information. The information in this document is also not intended to be a complete statement or summary of the industry, markets, securities or developments referred to in the document. Any opinions expressed in this document, including as to future matters, may be subject to change. Opinions as to future matters are predictive in nature and may be affected by inaccurate assumptions or by known or unknown risks and uncertainties and may differ materially from results ultimately achieved. Past performance is not an indicator of future performance.