No time to panic for fixed income investors
The 20-year bond bull market might be over, but there is still a place for fixed income in investors' portfolios.
Mentioned: ANZ Group Holdings Ltd (AN3PG)
The 20-year bond bull market might be over, but there is still a place for fixed income in investors' portfolios.
That is the message from Morningstar analysts after recent heightened volatility in financial markets pushed benchmark US bond yields to new highs.
A recent surge in the US 10-year Treasury yields to a seven-year high of 3.26 per cent sparked a rout on equity markets, amid expectations of further hikes to official US interest rates and fears over the impact of a US-China trade war.
J.P. Morgan sees the benchmark yield climbing to as high as 4 or even 5 per cent
Morningstar's John Likos, director equity and credit research, Australia, suggests investors heed the US Federal Reserve’s projections when determining future policy changes.
"The Fed has already indicated they're expecting to make one more increase this year, three more next year and one more in 2020 – that’s as good a guide as any,” he says.
"No one knows exactly how many times they're going to move, but if you use that as your benchmark, you probably can’t go too wrong. So the federal funds rate probably is going to be at 2.75 per cent to 3 or 3.25 per cent by the end of next year”.
Fed economists see the current US expansion ending around 2022, about the same time as the benefits from recent tax cuts start fading, with a subsequent slowdown but no recession.
However, other analysts have warned of even faster rises in US interest rates and bond yields. J.P. Morgan sees the benchmark yield climbing to as high as 4 or even 5 per cent, should the Fed continue increasing interest rates every quarter through 2019.
RBA may be forced to act
Meanwhile in Australia, the Reserve Bank of Australia (RBA) has left official rates unchanged since August 2016, with current market expectations pointing to no movement until 2020 at the earliest.
Morningstar's Likos suggests rising US interest rates will have a negative influence, particularly on longer duration bonds, as well as putting downward pressure on the Australian dollar.
The Australian dollar dropped by 4.6 per cent against the US dollar in the September quarter and the RBA might be forced to act, should the currency weaken further.
"There's the potential for imported inflation, which is a traditional enemy of fixed income securities. If you have increasing inflation, you could have a scenario where the RBA might try and get ahead of the curve and increase rates, although that’s contingent on other sectors of the economy, particularly housing," he says.
Corporate credit, hybrid markets holding up
Despite the bond sell-off, Likos says the investment-grade corporate credit market and hybrid markets have both performed reasonably well under the circumstances.
"High-yield has come off, but the investment-grade corporates are holding up pretty well. As always, it's critical to focus on the credit quality of the issuer, and that’s still important," he says.
In the hybrid sector, the September quarter saw a relatively strong 2 per cent return. Major bank hybrids outperformed, narrowing by 52 basis points on average, while corporate hybrids also posted gains, narrowing by 28 basis points on average.
Among those rated by Morningstar, Likos pointed to ANZPG, MQGPB and SUNPF, all with four-star ratings as at 29 September.
Yet amid the prospect of further rises in bond yields, how should fixed income investors react?
Likos says the first response should be to "stay committed to the asset class".
"Let’s not throw the whole asset class out the window due to the risk of increasing rates. It’s a very broad asset class which serves a unique role in any portfolio in preserving capital and ideally generating a real rate of return," he says.
"In this environment, you probably want to lower your duration and credit risk. So really understand the issuer – don’t go jumping into high-yield, funky, exotic products promising returns that are too good to be true, as they probably are."
With the end of the bond bull market, he sees credit spreads widening further in 2019, making it more important for investors to be selective.
"Maintain a balance of fixed and floating rate exposures and consider lowering some of the duration in your portfolio, as well as the credit risk. Don't stay away from fixed income but do your due diligence, as the risks are increasing for this asset class."
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Anthony Fensom is a Morningstar contributor
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