Keep calm and carry bonds

Ian Martin looks at the Australian bond market and how the changes in market expectations have an effect on bond indices.

Thirty years in the bond market has taught me that interest rate traders do not like stability. They want interest rates to go up or go down. But, there are ways to successfully build a defensive fixed income portfolio when the direction of the next interest rate movement is unclear.

Chart 1: Implied RBA cash rate as at 21 April 2017

Source: Bloomberg

RBA: Increase or decrease?

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One of the best indicators of market perception for future changes is the Australian Securities Exchange (ASX) 30-day Interbank Cash Rate Futures contract.  It implies where the Reserve Bank of Australia (RBA) official cash rate (the ‘OCR’) will be at a forward date. 

Currently the market implies an OCR of 1.46 per cent in Dec 2017 (0.04 per cent below present) i.e. not much will change from now.

By tracking the implied yield of the December 2017 contract since it listed, you can see it has been as low as 1.22 per cent and as high as 1.66 per cent. So what is it to be, a cut or a hike?

Market expectations and index performance

We now compare changes in market expectations of the RBA for December 2017 and the effect on the Bloomberg AusBond Composite Index (the Bond Index), which is often used as a benchmark for fixed income funds.

Chart 2: Dec 2017 implied cash rate over time

Source: Bloomberg

Chart 3: Dec 2017 implied RBA cash rate vs Ausbond Composite

Source: Bloomberg

Several things are obvious over the short-term (June 2016 to April 2017):

• As expectations of a rate rise occurred, the Bond Index fell (albeit for a brief time). This makes sense – as yields or interest rates rise, prices of bonds generally fall as an immediate response; and
• Therefore, the timing of investment in index-benchmarked funds – either making a new investment or selling an existing one – is very important.

There is a way to successfully invest in fixed-rate bonds in these uncertain times.

A comment on the Bond Index to begin, if all bonds in the Bond Index were described as a single bond, it would have an average life of 5.95 years and a yield to maturity of 2.37 per cent (21 April 2017). 

This concept of average life is important, as longer dated bond prices move more than shorter dated bond prices for the same yield or interest rate change. Bloomberg sub-indices based on term to maturity demonstrate this effect. 

The difference is dramatic. The 10 to 15 Treasury Index experiences large changes in price while the zero to three Treasury Index is relatively stable. The zero to three Treasury Index was almost untouched by the change in market expectations of interest rates.

The zero to three Treasury Index contains only government bonds, so it has a low yield of 1.66 per cent. This is no surprise, as it is similar to lending money to the RBA for three years. 

Chart 4: Performance of bonds in the Treasury Index: Zero to three years vs 10 to 15 years

Source: Bloomberg

Comparing the zero to three year Treasury Index with the equivalent zero to three year Credit Index of short-dated corporate bonds, investors get the same protection from interest rate sensitivity but have benefited in yield terms from investing in senior corporate bonds.

Chart 5: Credit index (corporate bonds) has provided a higher return

Source: Bloomberg

Many of these companies are ones you’re familiar with, such as major banks, Qantas and Wesfarmers. It is important to note that lending to a corporate or bank has a higher risk of default than lending to the government.

That’s why the yield is higher.

The change in credit spread or the additional price the market is willing to pay for the credit of a company compared to a government bond has also had a positive effect on the Credit Index’s performance.
Since June 2016:

• Three-year bonds (government and corporate) have been relatively stable and less sensitive to interest rate changes than the Bond Index and longer-dated bonds;
• Investors in longer-dated bonds need to be mindful of the timing of their investment if they do not intend to hold the investment to maturity; and
• Investors in shorter-dated bonds can worry less about timing – especially if they intend to hold the bond to maturity.

The sweet spot: Three to five year sector

The chart below compares performance of the Credit Index and the Treasury Index for different maturity buckets. Exposure to both types of bonds are available on the ASX. 

• Over the period, Credit Indices have outperformed their government equivalents; and
• The three to five year Credit Index has had the highest return over this relatively short investment period.

Note: The market’s pricing of credit spreads has also affected the performance of credit indices. 

Chart 6: Index returns 30 June 2016 - 21 April 2017

Source: Bloomberg

How to execute your strategy? 

In Australia there are managed funds that try to remove interest rate exposure, but there are none that allow you to specify your own maturity profile. 

Government bonds have been on the ASX since 2012, allowing investors to create their own portfolio; the ASX calls them Australian Government Bonds (AGBs). 

For corporate bonds, investors have been able to create their own portfolio since 2015 when Exchange Traded Bond units (XTBs) became available on the ASX.

Ian Martin is co-founder and executive director at the Australian Corporate Bond Company.