Investment Matters

Risks of bond rates rising

The media is starting to cotton on to the implications for bond rates, interest rates and inflation expectations following Donald Trump’s victory.

The graph below depicts the Australian 10-year bond rate nominal and real (i.e. adjusted for inflation).  As can be seen, there has been a meaningful tick up in the rate over the last few weeks – but really only to take the rate back to what it was to start the calendar year.

Long term bond rates

Why the uptick?

The Trump election was the instigator of the uptick.  Trump's promises of decreased taxes (personal and corporate), along with stimulatory measures such as infrastructure spending, are seen to increase economic activity and inflation pressures.  In this environment, such low rates (negative in effect) are not feasible, and will increase.  Additionally, Trump has been fairly open regarding his views on the US Fed Reserve, and in particular his view they have been holding rates too low and that this must change.

But what is oft forgotten is that we were on the path to higher rates irrespective of Trump – the US economy was tracking along quite nicely, unemployment low etc.  Inflation was also showing some minor signs of life (e.g. US wages inflation).

With globally interconnected markets, higher rates in the US ripple around the world.

Where to from here?

The question from here is whether things settle, or whether this is the start of the return to more normalised levels (i.e. akin to long term averages).  Without a crystal ball, the answer is not identifiable, or really even guessable.

What is clear is that asymmetry exists.  There isn’t really material downside if rates go backwards from here.  But there is clearly the ability for normalisation to higher rates to occur.

Implications of higher rates

With the increase in bond rates, many bond investors will take a hit on their investments (Some investment 101 stuff here: bond rates and bond prices work inversely. So if bond rates rise, the prices drop.  Like any other asset, a fall in prices means losses).   

This is actually a much more significant statement than would appear at first glance, given global bond markets are at least three times the size of global equity markets; greater than US$90 trillion (according to the Bank of International Settlements, the central bank for central banks).

More broadly, higher bond rates will impact everything from borrowing rates, to commercial property valuations, to the sustainability of sovereign debt for a number of countries.

And it may mark the return of bond vigilantes (investors who sell bonds and push up the rates on new issues, so that the cost of funding becomes excessive; something that Trump may be forced to consider with the likely increase in US debt levels under his proposals).

The implications for higher rates are more substantial now than ever, as debt levels around the world (and in Australia) have actually been increasing since the GFC.

Real vs nominal

The graph above highlights how artificially low rates are when considered from a real perspective (i.e. allowing for inflation).  The real Australian 10-year bond rate touched on zero recently.   Even post the recent uptick in rates, the real rate remains very low.

If we do see any increase in inflationary pressures, the impact on interest rates in real terms – which is what people actually feel – is going to be material.

Opportunities

We are actively seeking opportunities to invest in this environment.  Rising rates would be good for some companies we already own – QBE Insurance is a case in point.   Additionally, the Crown Notes II (CWNHB) were recently added to the equity portfolio.  Its income distribution is tied to the Bank Bill Swap Rate (BBSW) - which is an interest rate measure. 

On the flip side, we are aware of the potential risks.  We recently repeated an interest rate stress test of property investments (considering for instance sustainability of distributions, and when debt refinancing is due).  We remain cautious in relation to this allocation.

Conclusion

Predicting the outlook for interest rates (without that elusive crystal ball) is dangerous.  However, we see asymmetry in the outlook for rates, and are mindful of the risks and opportunities that this presents.