Bonds are back in town
Fixed income is the unsexy cousin of equities but it’s a useful diversifier—and you’ll impress your friends if you can explain it.
Bond yields are rising. The 40-year bull market is over. Inflation is going to rise and the official cash rate in Australia will not be at 0.1 per cent by 2024. So said Peter Warnes this week in a wide-ranging and fascinating overview of the February earnings season and the manoeuvring playing out in the bond market. To understand the ramifications, you can watch the webinar here; after that I urge you to read Graham Hand’s lucid overview of what rising bond yields mean for equities.
If you’re like me, this week’s frenzied talk of rising bond yields will have had you reaching for the financial glossary to refresh the mind on fixed income, what it is and how it functions. Granted, fixed income may not be in the barbecue-stopper class of other topics such as cryptocurrency or short-selling, but the hope is to explain what fixed income is and how it works, thus enabling you to diversify your portfolio and impress your entourage while you’re at it.
It's often said that the mark of a true diversifier is an asset class that shelters your portfolio when the proverbial hits the fan. And fixed interest is a bit like that. It’s often likened to an insurance policy: unsexy but safe when volatility strikes riskier assets such as shares or property.
Fixed interest is synonymous with bonds—a form of interest-bearing IOU. There are several types of bonds, with different "durations", from safer government bonds to more risky corporate bonds.
In short, when you buy a $1000 bond you're effectively lending money to the issuer, the government or a company, so it can fund its spending. It agrees to pay your principal back in, say, 10 years but along the way rewards you with a small interest payment of $50 a year—a 2.5 per cent "coupon rate"—a couple of times a year. A stable, predictable income stream.
"The global bond market offers investors a wide range of investments that they may otherwise be missing out on," says Morningstar associate director, fixed income strategies, Tim Wong. "Global government bonds, credit, securitised debt, and even currency bets can perform very differently to equities and cash and help a portfolio handle a greater variety of market conditions—both good and bad.”
Fixed interest may occupy a lower rung on the risk ladder but remember that bonds are sensitive to interest rates. Falling interest rates push up bond prices, and vice versa. When current interest rates are greater than a bond's coupon rate, the bond will sell below its face value at a discount. When interest rates are less than the coupon rate, the bond can be sold at a premium—higher than the face value.
Consider a 10-year, $5000 bond with a coupon rate of 5 per cent. If interest rates rise, new bond issues might have coupon rates of 6 per cent. This means an investor can earn more interest from buying a new bond instead of yours. This reduces your bond's value, causing you to sell it at a discounted price.
If interest rates fall, and the coupon rate of new issues falls to 4 per cent, your bond becomes more valuable, because investors can earn more interest from buying your bond than a new issue. They may be willing to pay more than $5000 to earn the better interest rate, allowing you to sell it for a premium.
$10k growth: PIMCO Australian Bond, PIMCO Global Bond, S&P/ASX 300
Source: Morningstar Direct; data as at 5 February 2021
Currency losses are another factor to consider, Wong says. "A sharp fall in the Australian dollar can lead to currency hedge losses that need to be funded out of income, which can lower or even cancel out a distribution entirely."
It's also crucial to consider the credit rating, or quality, of a bond. In short, the ability of an issuer to repay its debts. All other things being equal, the lower a bond's credit quality, the higher its yield. That's why you can find a high-yield bond fund with a yield of 7-8 per cent or more, while many investment-grade bond funds offer yields around 4 per cent. Because investment-grade issuers are more likely to meet their obligations, investors trade higher income for greater certainty.
AAA indicates the highest credit quality and D the lowest. So if you hold a bond rated AAA, AA, A, and BBB it's likely you'll collect all of your coupons and principal. Bonds rated BB, B, CCC, CC, and C are non-investment-grade, or high-yield, bonds. That means there's a good chance that the bond issuer will renege on its obligations, or default. In fact, D, the lowest grade, is reserved for bonds that are already in default. Lower-rated bonds tend to drop in value when the economy is in recession or when investors think the economy is likely to fall into a recession.
Bond funds and exchange-traded funds can be a flexible way to gain exposure to markets and sectors around the world. Among our selection is PIMCO's Australian Bond fund, which Wong rates as an excellent core defensive allocation. It invests in Australian cash, government, semi-government, and corporate securities, much like its Bloomberg AusBond Composite 0+Yr Index benchmark. Wong also rates PIMCO's Global Bond fund, which takes a benchmark-aware approach, sticking chiefly to investment-grade government and corporate bonds in developed markets, venturing into high-yield, inflation-linked bonds, and securitised and emerging-markets debt when opportunities emerge.
In Firstlinks this week, Graham Hand deconstructs the two new buzz words that Josh Frydenberg and Jane Hume are floating as “solutions” to the superannuation conundrum. And Roger Montgomery chimes in to separate the froth from the bubble in markets.
Elsewhere, the rise in bond yields has big implications for companies with high earnings growth, including some Aussie tech plays, writes Nicki Bourlioufas.
Christine Benz reveals four retirement blind spots; John Rekenthaler examines the runaway success of the ARK investment fund, and wonders whether the tail is not wagging the dog.
What Berkshire Hathaway’s chairman left out of this year’s annual shareholder letter is almost as notable as what he put in. Susan Dziubinski investigates.
When it comes to ETFs, does size matter? The appeal of low-cost investment options continues to pull investors towards passive and strategic-beta ETFs, writes Anthony Fensom.
American Century’s Brent Puff urges investors to steer clear of Tesla, and instead look at component makers such as Aptiv, NXP and Cree as an investment choice.
And finally, Emma Rapaport quizzes Morningstar analyst Adrian Atkins on the much maligned energy generator AGL and whether it can make a comeback.
Morningstar's Global Best Ideas list is out now. Morningstar Premium subscribers can view the list here.
