Friday 26 June 2015
The outlook for fixed interest investment
Should investors stay with bonds?
In most of the world's developed economies, bond yields are trading at historic lows. At the same time, cash rates are at 2.0 per cent in Australia, and near to zero per cent in many developed economies. In fact, they're even negative in some European markets – which means people are paying banks to hold their money for them.
This fall in yields has resulted in strong returns from fixed rate bonds in recent years.
The question for investors now is whether this situation can or will continue.
Key drivers of bond yields and interest rates
Bond yield performance has been driven by two key trends:
- The global economic growth outlook has continued to moderate, influenced by ongoing weakness in Europe and signs of a slowdown in China.
- Fixed interest market yields have been artificially held down by central bank quantitative easing (QE).1
Due to the unpredictability of the central bank actions, economic factors such as growth and inflation are no longer as useful as a means of forecasting investment returns. Bad economic news has been treated as good news as rates may stay low for longer, and now good economic news in the US is being treated as bad news by markets as it means rates may rise sooner than expected. There is also uncertainty about what will happen when this unconventional monetary policy is removed.
The US recently ended QE. Europe and Japan, however, have announced expanded QE programs over recent months. These divergent impetuses are driving currency markets and world interest rates.
A key risk on the horizon is the uncertainty about when the US Federal Reserve (Fed) is likely to start raising its cash rates.
The Fed continues to say it will be led by the data, although the market continues to push out the decision on a US rate rise. When rates do rise, many in the market could get caught out, and this might be the catalyst for both a period of rising US bond yields and increased global investment market volatility, across both fixed interest and equity markets.
As the Reserve Bank of Australia (RBA) suggests in its Financial Stability Review, March 2015, "to the extent that some end investors may not have appropriately priced liquidity risk to reflect a structural decline in market liquidity, there could continue to be some sharp adjustments, including in bank and corporate bond markets."2
More recently the European bond market sell-off led by Germany has also resulted in increased volatility at the same time as negotiations between Greece, the EU and IMF continue to languish – with increasing risks approaching from their ongoing stalemate. Effectively Greece is reluctant to force more austerity on its citizens, whilst the EU is unwilling to continue to provide unconditional financial support. There remains a high risk Greece could in-fact default and leave the EU, which will increase volatility globally if that occurs, although in the long term may be the best outcome for Greece.
Australian interest rates meanwhile are driven by the outlook for growth, inflation, risk premiums, issuance, currency and world interest rates.
The shorter end of the yield curve is influenced more by the outlook for domestic cash rates (set by the RBA). The longer end of the yield curve is driven more by global interest rates. This puts the Australian 10-year bond yield at risk from rising US interest rates later this year.
The trading values of fixed rate bonds have an inverse relationship with interest rates. As rates fall, capital values increase. This is, however, a two-edged sword – when rates rise, capital values decrease.
Such interest rate risk is called 'duration'. The current duration of the Bloomberg Ausbond Composite Index 0+yr is approximately 4.6 years (and has been drifting longer over recent years due to increased issuance from the Australian Government).
For now, the RBA has cut the cash rate to 2.0 per cent. Should Australia enter a recession there remains a risk the RBA may continue to ease the cash rate to below 2 per cent.
At the same time, the premium levels above this rate paid to term deposit investors have continued to decline (particularly at the wholesale end of the market). This has resulted in investors looking for higher yielding, yet still low-risk, investment opportunities.
High yield and low risk are, however, mutually exclusive. Risks generally increase as the expected yield rises.
Unfortunately for many investors, Macquarie Private Portfolio Management (MPPM) expects the recent trends to persist as the Reserve Bank continues to ease interest rates and volatility from Europe drives markets.
Late this year however, will see increasing risks as the US is expected to start raising rates.
MPPM continues to see the merits of holding some high-quality fixed rate bonds as part of a portfolio diversification strategy. This also gives the portfolio a potential 'flight to safety' benefit.
Currently, our preferred portfolio positioning remains short duration (i.e. mainly floating rate securities). This limits the sensitivity of the portfolio's valuation to any interest rate increase.
As investors move away from cash, they have a materially different risk/return profile. MPPM therefore cautions investors from moving too far down the quality curve to simply chase yield without an appropriate understanding of the risks. We also believe having some exposure to cash will enable investors to take advantage of any increase in market volatility.
Michael Frearson is a Senior Portfolio Manager with Macquarie Private Portfolio Management (MPPM).