A Guide to Exchange-Traded Australian Government Bonds
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Australian Government Bonds (and eTBs) are arguably the safest investment in domestic financial markets. The risk of default on these securities is zero (or very close to zero). These securities are the benchmark for all risk assets. Investors should utilise exchange-traded treasury bonds if their primary goal is stable income and capital preservation.
Investment in these securities means surety in timing of interest payments and principal upon maturity. But there are risks - interest-rate and inflation risk.
Inflation is the enemy of government bond investing, as rising inflation (CPI) reduces the value of future cash flows. This risk is discussed in more detail later in "Inflation and its Impact on Government Bonds".
Interest-rate risk in its simplest form is about understanding the inverse relationship between price and yield, and knowing how the yield of a particular instrument is affected by market sentiment and monetary policy positioning. It is important to recognise that interest-rate risk is a mark-to-market risk, and that if investors hold to maturity, they will receive their expected returns.
Duration: How to Measure Interest-Rate Risk
Duration is the most commonly used measure of interest-rate risk. It attempts to quantify the effect of changes in interest rates on the price of a particular security. The longer the duration, the more sensitive the bond or portfolio is to changes in interest rates.
Before we explain duration, it is important that we clarify a few variants on the word which do not have the same meaning.
Macaulay Duration: This is a measure of time and is defined as the weighted average maturity of cash flows for a particular security, measured in years.
Modified Duration: This is defined as the price sensitivity of a security for a given unit change in yield (usually 1%). This is a linear approximation for a given price/yield.
Effective Duration: This is used when bonds have embedded options. The optionality of the bond changes its mark-to-market profile, so modified duration is not a good measure. Effective duration is a discrete approximation of the slope of the bond's value as a function of the interest rate.
Figure 2: The Price/Yield Relationship
Source: Morningstar analysts
For investment in Australian Government Bonds, the most appropriate measure of interest-rate risk is modified duration. For example, the price of a government bond with a modified duration of two years will rise (or fall) 2% for every 1% decrease (increase) in yield. So the longer the duration, the more sensitive a security will be to movements in the yield.
Duration and Your Portfolio
When building an income portfolio, most investors appreciate the benefits of diversity but are not always aware of the benefits of duration. Historically, Australian investors have had exposure to ASX-listed interest-rate securities, which are predominantly short-duration instruments, and hence investors were unable to increase their portfolio's duration. With the introduction of eTBs, this attribute can now be added to portfolios.
We categorise interest-rate portfolios into three duration groups:
Short-duration portfolios: These maintain average portfolio duration of zero to two years. These should be less volatile than longer-duration strategies, which are often used as an alternative for traditional cash vehicles such as cash management accounts. In a low-interest-rate environment, a low-duration portfolio can be a higher-yielding alternative to money market funds for investors willing to accept additional risk in pursuit of greater return.
Moderate-duration portfolios: These maintain average portfolio duration of two to five years. This is appropriate for investors who are looking for slightly cash-enhanced returns with a moderate conviction on the expectation for interest rates.
Long-duration portfolios: These maintain average portfolio duration from six to 25 years. This is appropriate for investors with a long-term liability to match, or expectation of steady or declining interest rates that the market has not yet priced in. Long-term cash flow of government bonds provides certainty over a long time horizon and does not share the same volatility of equity markets.
Government bonds play an important role in every diversified portfolio, primarily because they are negatively correlated with equities. When share markets run into trouble, there is a general flight to quality and government bonds outperform. Those with longer duration tend to do the best. So, bonds soften the blow of losses in an investor's shareholdings. By avoiding omitting bonds from a portfolio, investors also sacrifice that diversification benefit.
Although duration is an important tool in constructing portfolios, it is important to understand that long duration positions can also produce negative returns. At present, global central banks are pouring money into financial markets to stabilise the world's major economies and artificially deflate interest rates. Australia has also seen a significant easing in monetary policy over the past 18 months, and long-duration portfolios have substantially outperformed.
However, we are now at a tipping point where the government bond market is pricing in a number of interest-rate cuts in 2013 to a point where yields are very low relative to inflation. Investors should be aware that if yields start to rise, they will be subject to negative returns.
Figure 3: Total Return of ASX 200 versus
UBS Composite Long Duration Index
Sources: UBS, Standard & Poor's