Insight

The future of bonds and fixed interest

26 May, 2021

A fundamental principle of bond investing is that interest rates and bond prices generally move in opposite directions. So what is the future of fixed interest in a near negative interest rate environment?

At the time of writing the more upbeat global economic outlook has meant investors have had more confidence in growth assets, like shares, and they’ve fled from defensive assets, resulting in a huge sell-off in bond markets.

The increased economic confidence has also led to concerns about inflation and that Central Banks, such as the Reserve Bank of Australia and the US Federal Reserve, may start to taper their extraordinary monetary support going forward.

A fundamental principle of bond investing is that interest rates and bond prices generally move in opposite directions. It may seem strange, but when interest rates rise, the price of bonds falls.

These factors saw the Australian broad bond index (Bloomberg AusBond Composite Bond 0+ Index) post its worst monthly return on record for the month of February 2021, with Australian 10-year government bonds selling off almost 0.80%. Global bond markets also suffered heavy losses. Should investors now steer clear of this asset class?

The relationship between share markets and bond markets

Before the recent bond market sell-off, fixed income had been on a 30-year ‘bull’ run. It has acted as an important cushion in diversified portfolios, offering a degree of protection when growth assets, like shares, have fallen. Why so?

Theory states shares and bonds are negatively correlated, that is, as one goes up, the other should come down. Looking at why, we see that government bonds tend to rise in value when markets are stressed because investors tend to rush to them as a safe haven, reasoning that governments will always be able to pay investors, even if the private sector is collapsing. Further, most global financial services companies, such as banks, must hold some government bonds for regulatory reasons. The government backing means there’s always liquidity, meaning capital can be sold down quickly in times of market stress.

We saw the negative correlation with shares and bonds play out strongly in the first half of 2020 when the lockdown measures put in place to control the spread of COVID-19 and overall pandemic uncertainty were hitting global economies hard and throwing share markets into a downward spiral. At this time the Australian share market (ASX 200) dropped over 10% while Australian government bonds provided a solid positive return.

What are bonds? And what’s fixed income?

Less volatile than other asset classes, such as shares, bonds are usually a relatively stable investment which can also provide regular income. In general terms, bonds are forms of debt issued by companies and governments when they want to raise money.

The term ‘fixed income’ is often used instead of the term ‘bonds’. This is because bonds are the most well-known type of fixed income security (a ‘security’ is the name of any tradeable financial asset). Fixed income is a way of describing a security where the issuer must pay the lender fixed payments at fixed times.

It’s worth noting that fixed income doesn’t mean a fixed dollar amount is paid, as bonds can have either a fixed or 'floating’ rate that moves up and down with the market or an index, so the word 'fixed' refers to having to make payments at set times.

The best of both worlds

The negative correlation means that many investors choose to hold both bonds and shares in a diversified portfolio to protect their capital and smooth returns. It's also not uncommon for bonds and shares to deliver positive returns at the same time, as was the case in 2019.

Our Head of Fixed Interest Assets, Osvaldo Acosta, states “while the bond markets have fallen, it’s still possible to construct a fixed income portfolio that delivers income and protects capital.” It may just be that the current economic environment demands a more thorough, ‘active’ investment approach. In addition, Osvaldo explains, “the recent sell-off in bond markets presents opportunities because it’s an asset class now at good valuation levels.”

How do we apply an evidence-based investing approach to fixed income?

At Shadforth, we apply evidence based principles to fixed income investing.  We work with managers to construct portfolios based on 3 factors that over time have demonstrated higher expected returns in fixed interest markets:

  1. DURATION: This measures the sensitivity of bond prices to changes in interest rates. The higher expected returns of longer duration bonds compared to shorter duration bonds is known as the term premium.
  2. CREDIT: This is measure of the likelihood of the bond issuer defaulting. For this reason, a top−rated government bond will perform differently to a low−rated corporate bond. The higher expected return associated with a lower credit quality bond is called the credit premium.
  3. CURRENCY: Bonds are issued in different currencies. So, US dollar bonds may behave differently and offer higher return to European or Australian dollar bonds
What should investors do?

Fixed income can still play an important defensive role in a diversified portfolio but it’s a complex asset class, particularly now we’re at a turning point as the economy recovers from the pandemic recession. Further, there are many levers that can be pulled in order to navigate fixed income successfully and specialist expertise can make all the difference.

Your Shadforth adviser is best placed to help you assess which asset classes will form the right investment mix for your own personal financial situation, so speak to them about the role fixed income may play in a portfolio that helps you to achieve your overall financial objectives.