19 Dec 2023
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After a horror 2022, AMP Portfolio Manager Fixed Income, Chris Baker says bonds are coming back into favour as interest rates near their peak.
Before we take a closer look at the current state of the bond market, it’s worth a recap on how bonds work.
Most people are pretty familiar with the share market. When you invest in an equity, you’re providing capital to a company that needs to raise funds.
A bond is just another instrument to raise capital. The main difference is that a bond usually has a set maturity date when you get your capital back and you earn coupons or interest over the course of that investment.
So if I buy a BHP bond for $100 it’ll generally have a maturity date of say three, five or seven years (bonds are issued with varying maturity dates) when I’ll get back the $100 I invested, plus I’ll earn interest during that time for lending BHP the money. Like other investments, throughout a bond’s investment term, factors such as changes in interest rates, inflation and expected default risk affect the value at which a bond will trade on the secondary market before it matures.
Bonds typically also offer more protection than equities. So, if the company defaults (or put another way, goes bankrupt), equity investors wear losses first.
That’s why bonds are considered less risky than equities.
All shapes and sizes
Bonds are used by many different organisations to raise money – from companies like BHP and Coca-Cola all the way through to sovereign states.
- Bonds issued by governments in developed economies are the least risky as the likelihood of default is very low – after all, if the Australian Government defaults on its debt, we’ve got some serious problems!
- Bonds issued by governments in emerging markets come with a little more risk.
- And then bonds issued by corporates have more risk of default as they’re not guaranteed but they tend to compensate investors through higher yields.
Rates up, bonds down…and vice versa
When you buy a bond, you’ll see a quoted yield to maturity (YTM). That’s effectively the return you’ll earn, assuming you hold the bond to the end of its term.
Like any loan, bonds generate interest payments and so the movement of interest rates will affect the value of a bond from when you invest to when the bond is repaid.
There tends to be an inverse relationship between bond prices and interest rates.
As interest rates increase, the trading value of existing bonds goes down as people can buy newer bonds at more attractive rates.
And when interest rates are falling, the value of existing bonds increases as new bonds are being issued at lower rates.
Post pandemic hangover
So what’s been happening on the bond market in recent years?
During Covid, central banks cut rates to extremely low levels along with other measures aimed to stimulate growth via injecting money into the economy (called quantitative easing). Governments also implemented fiscal stimulus measures to protect the economy from falling into a deep recession. And as we emerged from the pandemic, they unwound these cuts with extremely aggressive increases because inflation was becoming a problem after so much monetary and fiscal stimulus.
The result? Bond returns in 2022 were the worst they’ve been in more than 50 years.
But now with interest rates now at more normalised levels, the income you’ll accrue from investing in a bond is far higher.
Put it this way. Going back to Covid, bond yields were close to zero, depending on maturity. Now the YTM on a 10-year government bond is close to 5%.
Income and protection in retirement
With the cash rate at 4.35%, term deposits and other fixed income investments like bonds are far more attractive than they’ve been for many years, particularly in retirement, when investment income becomes more important.
Bonds deliver a regular income stream through coupons – generally every six months. They are higher risk than term deposits but similar in that you’re earning income through the life of the investment, albeit over a longer period.
So as bonds are less volatile than equities, they can provide protection and an income stream at the same time.
A bumper year ahead for bonds
In 2022, the bond market was very volatile. While it’s since settled down, it’s still higher than the 20-year average. And we expect this market volatility to continue in 2024 as inflation remains ‘sticky’.
If inflation stays above target levels, central banks like the Reserve Bank of Australia may have to hike rates further, negatively impacting bonds given the inverse relationship between bond prices and interest rate movements that we talked about earlier.
While we appear to be very close to the end of the interest rate hiking cycle, the outlook is a little uncertain. This certainly was evident on Melbourne Cup day this year when the RBA increased interest rates again by 0.25% to 4.35%, which is the 13th rate hike in just over a year. The problem is inflation data tends to lag – it takes some time for rate increases to flow through and affect the economy.
So there’s a lot of debate about how 2024 will look in terms of a soft or hard recession as a result of the aggressive rate increases we’ve seen.
If there’s an economic slowdown, the RBA may need to start cutting rates and bonds will start to do very well.
But whatever happens in 2024, bonds are paying yields that are the most attractive in many years. So they’re in a great place to provide a defensive role in an investment portfolio as a counterweight to more volatile asset classes such as equities.
Current as at Dec 2023
As always, if you have any questions or your personal circumstances have changed please do not hesitate to contact your financial adviser.
General Advice Warning - Any advice included in this article has been prepared without taking into account your objectives, financial situation or needs. Before acting on the advice, you should consider whether it’s appropriate to you, in light of your objectives, financial situation or needs.
