No more “Goldilocks” returns in bonds
Readers are aware that the interest paid on long term government bond rates has historically been a good indication of expectations for future growth and inflation.
With the economic outlook now improved, we saw government bond yields rise significantly this week - from 0.6% to 0.9%. However, yield is what you are paid on the price of your investment. And so, if bond yields rise, bond prices must fall
The result? The holder of a 10-year government bond has lost 30% of the interest they would have been paid over their entire holding period, in capital value.
This touches on a subject many have grappled with recently. Longer-dated government and highly rated corporate bonds have traditionally been considered a “safe” investment. However, the biggest risk in holding these securities may be the risk of rising interest rates or inflation.
Does an exposure to bonds still serve the same defensive purpose in a portfolio as it once did?
We argue it does not and have positioned client portfolios with a smaller overall exposure to bonds, with a broad exposure across different types of income securities.
Ballast or an iceberg?
Investments in government bonds have traditionally been thought of as a “risk-free” return. Who is more creditworthy than the government? Likewise, investments in highly rated bonds of large corporations have been a staple of income portfolios.
In the past, we have seen economic shocks and downturns countered by swift central bank action. With every economic hiccup, central banks have been there to pat the economy’s back, nursing it back to health with a dose of lower interest rates. And every time the interest rate lever has been pulled, bond prices have rallied, providing ballast to portfolios.
This can be seen in the chart below, which looks at the performance of the classic 60/40 portfolio (60% equities, 40% bonds) over several decades. A portfolio with a mix of equities and bonds is ingrained in investors’ minds due to the outstanding performance shown from the 80’s up until the global financial crisis (the period highlighted in green).
But what about in an environment where interest rates move higher? From 1964-1979 (the period in grey) bonds failed to provide that same protection.
The “rates go down, bonds (prices) go up” phenomenon, one that has instilled a sense of safety in bonds in past decades, has reversed and is now one of the biggest risk investors in these securities face.
While lower interest rates result in rising bond prices, higher interest rates result in rapidly falling prices. And interest rates have never been lower.
The result is these bonds no longer present “risk-free return”, many now present the opposite: a return-free risk.
Let us put ourselves in the shoes of the typical “bond investor” in the current environment.
This “bond investor” will only buy long term government bonds and highly rated bond issues.
The reward for lending money to the government for 10 years at the moment is a rather slim interest rate of 0.98% (Source: IRESS). Lending to a well-known and stable corporate, say Woolworths, won’t provide much more reward, at an interest rate of 2.8% for 10 years (Source: FIIG).
The bond investor might argue that “something is better than nothing” - a small return is better than “just cash”.
Potentially not. While cash may have a lower return, it can be utilised whenever we like, say to take advantage of future opportunities. By investing in a bond, our money is locked up. That is 10 years of missing out on the opportunity to do other things with that money, for a return of 1%!
But couldn’t you sell the bonds and instantly have your cashback? Yes, but there is a catch.
The chart below shows the impact on the value of a 10-year bond with varying changes in interest rates:
Now, if interest rates continue to head lower, the bond investor may feel quite smart. People would be willing to pay a little more for a bond paying 1% (perhaps 2-5% more) and they could cash out at a premium.
However, there is only so much more potential for rates to fall. Interest rates are now close to their historical lows, and the Reserve Bank has ruled out negative interest rates – as the international experience has been poor. We acknowledge that quantitative easing may hold rates lower, for now. But this does not protect the bond investor from the erosion of the purchasing power of their dollars through inflation (a lower “real return”).
Longer-term, interest rates may ultimately once again reflect future expectations about growth and inflation. So, what if interest rates head higher? That is when the bond investor hits the iceberg.
The chart above shows that the bond investor would lose 17% of the capital value of their bond were interest rates to return to levels seen in 2018.
Who would like to own a bond that is returning 1%, when others return 3%? The answer is nobody. And so, in this case, to exit their investment, the bond investor would have to take a big discount. The size of this discount depends on how long they have lent their money for (in finance jargon: duration) and the extent of the rise in interest rates. The longer they lend their money for, the higher the sensitivity to interest rates and the larger the loss. Likewise, the higher the rise in interest rates, the larger the loss.
Putting aside any view on future growth and inflation, a lower bound for interest rates means there is much more potential for loss than gain. We like investments that have asymmetric returns - but this is simply the wrong kind of assymetry.
Finding income in a low interest rate world
How do investors achieve income in a low rate world without taking on the same risk as the bond investor?
Realistically, most income investments are vulnerable to rising interest rates or inflation to some degree. And there is no more “risk-free reward” – long gone are the days where investors can expect a comfortable 5% return lending their money to the government.
In the current environment, there unfortunately is no easy answer. There is no Goldilocks borrower that presents no credit risk, will pay you a high rate of interest over a short period, and won’t leave you exposed to rising interest rates or inflation.
If one thing is clear, it’s that it is unlikely that a large allocation to government or low paying highly rated bonds (particularly those that are long-dated) will be as successful as it has in the past. Certainly not as successful as it has been over the last few decades. A different mix of income investments is needed.
Therefore, the challenge has become achieving the right mix of income investments, one which balances the riskiness of borrowers and the risk of rising interest rates - a function of how long we choose to lend for and the type of interest we are paid.
Our approach has involved a balance of the key variables when it comes to lending: how creditworthy the borrower is, how long we choose to lend for and the type of interest we receive.
Broadly, we have avoided investing in very long dated income investments, balancing this with the return we receive for lending for different lengths of time.
Portfolios still retain some exposure to government bonds and large corporates. However, we have also looked to lend to borrowers that provide a higher rate of interest than those provided by these lenders. The trade-off is that these are not always “traditional” investment grade or government securities and do present more credit risk. This is a function of the environment we are in today – there is no more risk-free return. However, we have looked to balance this credit risk through many small exposures and diversification across sectors.
We have also been more selective about the type of interest we receive. Clients are invested in a balance of securities that are less sensitive to interest rates by virtue of the nature of interest payments.
Examples include “inflation-linked” bonds (where interest payments rise with inflation), securities that pay a “floating” rate of interest (where interest paid adjustable and rises with rising short-term interest rates) and exposures that are neutral to changes in interest rates (such as “relative value” income strategies, which look to take advantage of differences in pricing between income securities).
Overall, the objective has been to create a balanced exposure with an awareness of the challenges faced, to achieve client return objectives over the long term.
Income investors face several challenges in the current environment, particularly the risk posed by higher inflation and rising interest rates.
An awareness of these challenges necessitates a shift away from a traditional bond portfolio and the careful balancing of a broad range of investments, rather than a search for elusive Goldilocks borrowers.