Fixed-income investors seeking safety in bonds be warned: it took only a relatively modest rise in bond yields over the past year for Australia’s headline bond index to post negative returns.
This result highlights the risks that traditional fixed-rate bond investments currently pose to investors in an environment of low but rising bond yields.
By contrast, floating rate bonds (FRBs) posted good returns over the past year, and appear well placed to outperform fixed rate bonds in a rising interest rate environment.
Higher bond yields leave Australian fixed-rate bond index investors exposed to losses
The headline bond index in Australia – against which many active and passive bond funds benchmark themselves – is the Bloomberg AusBond Composite Index (BACI).
One challenge with this index, however, is that it is dominated by fixed-rate government and corporate bonds, which means its capital return is highly sensitive to the changes in the general level of bond yields.
To explain why this is, let’s look at a simple example. Imagine a bond that promises to pay $5 at the end of a year plus a capital return at that time of $100. If the market demanded this bond provide a yield of five per cent, the market value of that bond today would be worth $100.
If, however, the market suddenly demanded that the yield on the bond increase to seven per cent (in other words if the bond yields rose) – without the $5 interest payment changing – the only way this can take place is if the bond’s market value today drops to around $98, or a capital loss of two per cent.
Given the nature of the fixed-income bonds in the Bloomberg AusBond Composite Index, estimates suggest a general one per cent rise in bond yields would lower its capital return by around five per cent and vice versa.
Such a negative relationship between capital value and yields has been evident over the past year. Importantly, although the Reserve Bank of Australia (RBA) left the official short-term cash rate on hold over the past year, the yield on Australian fixed-rate government bonds tended to rise – reflecting both reduced market expectations of further monetary policy easing in Australia and higher US bond yields.
Due to the rise in bond yields, the capital return from the Bloomberg AusBond Composite Index (and therefore passive products linked to this index) declined by around three per cent in the year to end-August 2017. This more than offset the BACI’s income return of 2.7 per cent, resulting in a negative total return over this period of 0.7 per cent.
Moreover, given the current annual income return from the BACI still remains fairly low, it would not take much of a rise in bond yields to produce further negative returns.
Floating rate bonds shine as interest rates rise
The price or capital value of floating rate bonds (FRBs), however, is much less sensitive to changes in the general level of market interest rates.
That’s because, as the interest payments of these bonds are linked to a benchmark rate (such as, say, the Bank Bill Swap Rate), to a significant degree, the dollar value of interest payments these bonds pay adjusts or “floats” to reflect the prevailing level of short-term interest rates. Using the hypothetical example, if interest payments on the bond were allowed to rise to $7 (rather than the $5 fixed payment we spoke about earlier), the capital value of the bond would not need to decline below $100 to achieve the higher yield of seven per cent.
Accordingly, the index of senior bank FRBs did not suffer any capital loss due to the general rise in bond yields over the past year. In fact, QPON’s index provided a total return of 3.8 per cent, reflecting an income return of 2.7 per cent plus some extra capital return due to a market re-rating of bank bonds generally.
The exhibit below shows the relatively wide variance in total returns for the year to end August 2017 from a range of bond indices.
A rising interest rate environment should continue to favour floating over fixed rate bonds.
The RBA recently reiterated that the neutral RBA cash rate is 3.5 per cent, or two per cent above the current 1.5 per cent level, and yet three-year government bonds are pricing in a sub two per cent cash rate while 10-year government bonds are pricing in less than 2.6 per cent.
Given the RBA’s position, bond yields are more likely to rise than fall looking ahead, and floating rate bonds appear particularly well placed to potentially outperform the widely followed AusBond Composite Index.
After all, not only will these bonds benefit from higher interest payments as and when the RBA lifts the cash rate, they should also not suffer the extent of potential capital losses BACI will be exposed to as bond yields rise.
Alex Vynokur is managing director of BetaShares.
