Most investors appreciate the role of fixed income in a diversified portfolio – steady income streams, lower volatility, and protection against falls in equity values during periods of market stress. However, by the end of June 2019 the Australian Government 10-year bond yield had fallen to an all-time low of 1.32 per cent. In the last two months the RBA cash rate has been lowered from 1.50 per cent to one per cent with many economists predicting further interest rate cuts to as low as 0.5 per cent.
The question often asked is whether an allocation to fixed income at such low yields is still worthwhile? To add to the conundrum, yields offered on international bonds are similarly at or near historic lows.
This article looks at a number of factors to consider when assessing whether allocating to fixed income in low-yielding environments still makes investment sense. In particular, we revisit the concept of yield to maturity (YTM) and look at the performance of fixed income over shorter timeframes, the role of diversification, and the risk of capital loss should yields rise.
YTM AND CHANGING EXPECTATIONS
Investors tend to focus on YTM as the single most accurate gauge of the future total return from their bond portfolio. However, YTM is only an accurate measure of total return if a bond is actually held until maturity.
Managed bond portfolios, whether active or passive, engage in a program of rolling bonds prior to maturity. The extent to which this occurs will affect the accuracy of YTM as a measure of the expected total return for the portfolio. More important is that for duration exposures, changes in expected economic conditions and investor sentiment have a far greater impact on bond returns over short to medium time frames than the yield itself.
As well as having important implications for portfolio outcomes, this also allows for investors to benefit from tactical allocations during certain market conditions.
Whilst the current low-yield environment may make it tempting to allocate to higher-yielding bonds (of lower credit quality and most often sub-investment grade), these assets are unlikely to offer meaningful diversification benefits in the event of market stress. In fact, given that credit risk premia and equity beta are positively correlated, high-yield bonds are likely to suffer from negative returns at the same time as equities during such periods.
Take for example the most recent market drawdown of Q4 2018. In the US the S&P 500 Index fell 13.52 per cent whilst the Bloomberg Barclays US Corporate High Yield
Bond Index fell 4.53 per cent. The flight to safety resulted in investors directing their flows to higher quality assets, and consequently, the Bloomberg Barclays US Aggregate
Total Return Index (comprising a broader set of investment grade bonds) returned 1.64 per cent for the quarter. US Treasuries, considered the safest of all bonds, benefited even more from the flight to safety with the Bloomberg Barclays US Intermediate Treasury Index increasing 2.24 per cent over the period (see table 1).
This reinforces the fact that over shorter timeframes bond returns are driven largely by changes to expected economic conditions and investor sentiment. It is this attribute that can provide additional sources of return to investors and/or diversify away the beta risk of equities.
The longer the duration and the higher the credit quality of bonds in the portfolio, the greater the potential diversification benefit and vice versa. Cash, whilst providing capital stability, simply will not provide the same level of portfolio insurance or diversification over such periods.
For example, the BetaShares Australian Investment Grade Corporate Bond ETF (CRED) holds a portfolio of fixed-rate corporate bonds, rated investment grade or higher. In the 12 months following inception on 31 May 2018, it returned 11.36 per cent, and just as important, provided diversification vs. the S&P/ASX 200 Index, as shown in chart two. The defensive benefits were especially evident during the stockmarket downturn in the last quarter of 2018.
INVESTMENT RISK FROM RISING YIELDS
Up until recently, many investors have been calling the end of the multi-decade bull market in bonds. However, history demonstrates that future yield levels are incredibly hard to predict.
While rising interest rates will have a negative impact on capital values of fixed income bonds, the overall effect may be less than expected for two reasons:
- Yield expectations are reflected in the yield curve: to the extent that interest rates are expected to increase, the chances are that this is already priced into bonds. Only to the extent that interest rates rise by more than what is reflected in the yield curve, will bonds experience further capital losses.
- Bond reinvestment into higher yields: As mentioned previously, bond portfolios engage in a program of rolling bonds prior to maturity. If interest rates rise, new bonds will be purchased at higher yield levels, dampening the initial capital impact of the rate increase.
Table 2 shows the cumulative returns in Australia over previous periods of interest rate hikes since 1990. Whilst negative returns can be experienced over short time frames (especially when significant hikes have not been anticipated such as in 1994), investors with a longer-term focus should still benefit from positive returns.
Whilst there will always be a focus on whether interest rates will move higher or lower, it is more important investors focus on the overall benefits of allocating to fixed income - diversification benefits, capital stability, and reliable income streams. A low-yielding environment does imply a lower income stream, but there can be no assurance that interest rates will not fall further in the future. The added diversification remains a key benefit. Whilst there will be investors who shy away from fixed income due to their view of the risk of rising interest rates – we view the overall long-term risk to portfolio outcomes of not allocating to fixed income to be even greater.
Louis Crous is CIO at BetaShares