Interest rates are tumbling globally as central banks attempt to bolster a weak economic outlook. Yet with bond yields falling and prices rising, the traditionally defensive asset class of fixed income is starting to excite investors.

In Australia, the Reserve Bank of Australia’s move to cut the official cash rate to a historic low of 1 per cent has pushed yields to all-time lows. After starting the year at 2.3 per cent, the official 10-year bond yield has almost halved amid expectations it could fall below 1 per cent by year-end.

Bond returns have soared as a result. US government bonds posted a 10.1 per cent gain over the year to July, while Australian 10-year government bonds returned 13.5 per cent, according to Pendal Group.

Bond bulls have invested some US$72 billion ($103 billion) into fixed income exchange-traded funds in the year through 24 June, with the funds set for record first-half inflows, according to Bloomberg Intelligence.

The prospects for even more bond gains appear bright, based on official commentary.

Explaining the latest rate reduction, the RBA governor’s official statement suggested more cuts could occur amid increasing “downside risks” to the global economy, together with below-trend growth in Australia, sluggish inflation and spare capacity in the labour market.

“The Board will continue to monitor developments in the labour market closely and adjust monetary policy if needed to support sustainable growth in the economy and the achievement of the inflation target over time,” the 2 July statement said.

A number of economists have projected the official rate could fall even further, to just 0.5 per cent by June 2020.

Others expect the central bank to pause its monetary easing, at least until year-end.

“Our expectation is that the RBA will leave rates at 1 per cent through 2019, with risk firmly to the downside. Typically, what happens when the RBA cuts is that short-dated bond yields drop below the cash rate, so quite a bit of the bond market could end up sub-1 per cent,” said Chris Rands, portfolio manager, fixed income at Nikko Asset Management.

“And once the market has digested what has happened, bond yields could sell off when they believe the RBA has stopped.”

Globally, investor expectations are pointing toward US interest rate cuts in 2019, with policy easing also expected in New Zealand, China, the Eurozone and Japan.

In the US, Treasury bond yields have dropped to their lowest levels since 2017, while yields are already negative in Germany, Italy and Spain.

Globally, negative yielding bonds have hit a new record high of US$12.5 trillion, changing investor expectations and challenging central banks.

Hybrid gains

Morningstar’s Australian Credit Monthly report for May noted the domestic hybrid market’s “strong run” following the 18 May federal election.

The results were immediately positive for hybrids, “particularly for major bank Additional Tier 1, or AT1, securities as cash refunds on franking credits were no longer at risk of being wiped out,” the report said.

Hybrids had “sold off aggressively” in March 2018 following the opposition Labor party’s announced policy change; however, the Coalition’s re-election has seen investors seek “longer-term, higher-yield hybrids”.

“More broadly, we’ve also observed that investors who previously exited their positions are now re-embracing the hybrid market,” the report noted.

Among Morningstar’s four-star rated hybrids as at 31 May were Macquarie Group Capital Notes 2 (ASX:MQGPB), with a “running yield” including franking credits of 6.44 per cent and Ramsay CARES (ASX:RHCPA), with a running yield of 6 per cent.

The ETF market has also increased its fixed-income offerings, with the latest launch the BetaShares Australian Government Bond ETF (ASX:AGVT).

Listed on 9 July, the fund offers exposure to bonds issued by Australian federal and state governments, sovereign agencies and other issuers.

Will the bond party last longer? 

Nikko AM’s Rands suggests the RBA might hit the pause button on its rate cuts, particularly if house prices recover. 

"We’re square interest rates after nine months of being overweight – typically bond yields rally when they cut, but if they only cut to 1 per cent we’re getting close to the end of the bond rally,” he says.

Yet regardless of central bank moves, fixed income will always have a role for investors, suggests Morningstar’s Tim Wong, director, manager research.

“Fixed income is primarily there to diversify an existing portfolio, particularly for investors with risky assets. When times get tough, as in the back end of last year, bonds have a different risk profile and can provide some portfolio insurance,” he says.

“For us, it’s all about what you want from asset allocation and thinking about your overall portfolio. For us, bonds belong in a diversified portfolio and have a defensive role to play”.