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A Guide to Exchange-Traded Australian Government Bonds

Nicholas Yaxley  |  19 Jun 2013Text size  Decrease  Increase  |  

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Active versus Passive Management

First and foremost, Treasury Bonds and Treasury-Indexed Bonds are defensive investment securities designed to reduce risk in a portfolio. These securities are the risk-free benchmark and can be used in ways to create secure, long-term income.

Historically, individual investors have only had access to bond markets through managed funds. These funds actively manage bond portfolios relative to a specified benchmark. In Australia, the most commonly-used benchmark is the UBS Composite Index.

The problem for investors is that fixed-income benchmarks present a number of complex issues which generally benefit issuers, not investors. The primary issues revolve around the fact that fixed-income benchmarks are capitalisation-weighted. This sounds normal, as is acceptable for equities, but in fixed income it creates two major complications.

The first problem stems from the fact that the duration of the benchmark comes from issuer preferences, and does not necessarily reflect the best interests of a given investor. When issuing bonds, the issuer is looking to optimise its duration preferences and, in the case of company issuers, minimise their cost of capital. Therefore, the benchmark duration is an aggregate of issuer preferences and not what investors should be focusing on.

The second problem is what is commonly known as the "bum's problem". This was originally identified in 2003 by Larry Siegel, who identified that market-weighted fixed-income indices were heavily-skewed by issuers with the highest debt outstanding. This seems perverse, as issuer creditworthiness and total debt volume are typically inversely-correlated.

These issues can be avoided by introducing passive and active bond investment strategies with exchange-traded treasury bonds.

 

Passive Bond Strategy

We define a passive investor as one who typically looks to maximise the income-generating properties of bonds without managing any of the risk. This is what is commonly known as a buy-and-hold investor.

This strategy assumes government bonds are safe and predictable sources of income. Investors purchase the individual bonds, hold them to maturity, and any cash flow from the bonds is used to fund external income needs or is reinvested in the portfolio.

Passive bond strategies make no assumptions about the future direction of interest rates and subsequent changes in the price value of the bond. Shifts in the yield curve are not important, but the main concern is that the par value will be received upon maturity.

On the surface, passive strategies appear to be a lazy investment approach, but in reality passive bond portfolios provide stable anchors in rough financial storms. They also minimise transaction costs, and if originally implemented during a period of relatively high interest rates, they have a decent chance of outperforming active strategies.

 

Active Bond Strategy

We define an active investor as one who is typically looking to maximise the absolute returns from investing in bonds by identifying a mispricing of risk or undervaluation within the market.

Active bond investors adjust the duration of a bond portfolio (that is, the weighted average duration of all the bonds in the portfolio) based on an economic forecast. For example, if an investor expects interest rates to decline over time, an active bond investor may decide to increase the portfolio's duration. This is because the longer the duration, the more price appreciation the portfolio will experience if rates decline. Conversely, if a bond investor believes interest rates will rise, they would ideally reduce the portfolio's duration by buying shorter-term bonds and selling longer-term bonds.

More complex strategies include positioning a portfolio to capitalise on expected changes in the shape of the Treasury yield curve. This is a complex and difficult task and we do not recommend it to inexperienced investors.

A shift in the yield curve refers to the relative change in the yield for each Treasury maturity. A parallel shift in the yield curve is a shift in which the change in the yield on all maturities is the same. A non-parallel shift in the yield curve indicates that the yield for maturities does not change by the same number of basis points.

Other strategies include a "bullet" strategy, whereby the portfolio is constructed so that the maturities of the securities in the portfolio are highly concentrated at one point on the yield curve. In a "barbell" strategy, the maturities of the securities in the portfolio are concentrated at two extreme maturities. In a "ladder" strategy, the portfolio is constructed to have approximately equal amounts of each maturity.

 

Conclusion

Whichever strategy an investor chooses, the goal of bond investing is to maximise total return and/or introduce defensive characteristics into the portfolio. Strategies for investing in bonds can be made simple or complex, depending on your understanding of risks and the goals each strategy is trying to achieve.

We recommend the buy-and-hold approach, which appeals to investors who are looking for income and who are not willing to make predictions. However, active investing can introduce a new element of absolute return to investors, which is evident from the return in long-duration bonds over the past 18 months.