Battered and bruised, but is it time for a bond bounce back?
Time to brush up on bonds? Check out our introductory series part one, two and three.
In the InvestSMART Diversified Portfolios bonds are categorised as defensive assets, used to supply ballast offsetting the more volatile growth assets such as Australian and international shares.
In theory, these assets should supply uncorrelated returns and when one is negative the other should be offsetting it. This has not been the case recently as the perfect storm has gathered and we’ve seen bonds and equity markets take a hit.
To further explain what has happened and what investors should expect in the future I posed three questions to InvestSMART Market Strategist, Evan Lucas.
Why have the ETFs IAF and VBND experienced price declines?
Over the past 6 months the markets’ expectations of interest rate rise has dramatically risen. This change in expectation is down to the surge in inflation, the higher-than-expected demand from the Australian consumer and global issues around supply and COVID-19 policies.
Off the back of these headwinds, the Reserve bank of Australia (RBA) has raised rates 75 basis points or 0.75 per cent in the past two months and is forewarning of further steep interest rate rises to come.
All this has led to Australian Commonwealth Government Bond (ACGB) yield repricing. For example, ACGB 10 year bond yield has moved from 1.79 per cent in December 2021 to 4.07 per cent as of late June 2022.
This rise in the yield is not exclusive to the ACGB 10 year either. All bond timeframes have seen this kind of appreciation in their yield component.
This has also cause a very sharp and painful decline in the price of ACGBs and all ACGBs currently on offer to the market are trading at discounts to face value. The face value for a bond is the bonds issue price. It's also the price the bond will be bought back at when it matures. As the coupon rate is fixed, the yield is determined by the movement on market. So as the price falls the yield increases. As prices rise the yield falls
IAF replicates the ACGB market. It invests across all time maturities and are also weighted according to the market capitalisation. This means that the biggest holding is the ACGB 10 year followed by the likes of the 3 year and 30 year bonds.
Considering the current climate, it is unsurprising to see the kind of sell-offs we are seeing. What should be noted is that this is abnormal. No one, not even global central banks saw inflation surging as it has. The recovery from the global pandemic has been faster, harder and more pronounced than even the most optimistic forecast – the result is now an inflation level not seen in decades and that is something economies need to fix. This is why bonds have been sold off.
VBND the global aggregate bond ETF is also facing the same concerns as global government bonds all face the challenge of higher inflation and thus higher interest rates.
What’s your outlook for these two ETFs?
What should be pointed out is that the discounts are already priced in. Investors need to understand that if you are to invest now and hold to maturity, you will get the face value which is higher than the current pricing. Couple this with current yields and the outlook for fixed interest over the coming years is clearly stronger than it has been over the past 18 months. IAF and VBND will in the near future benefit from investors buying discounted fixed income securities.
What to do if you already hold?
The current experience has been difficult no doubt and to see a defensive asset under a higher-than-expected level of pressure is hard to take. However, remember that fixed income will continue to pay you a guaranteed yield. It may also be an opportunity to look at adding to your fixed income positions to average down your price, gain a larger dividend from higher holdings and know that your current pricing is at a discount which will close up as bonds mature.
Frequently Asked Questions about this Article…
Bond ETFs such as IAF and VBND have seen price declines due to rising interest rate expectations driven by surging inflation, increased consumer demand, and global supply issues. This has led to a repricing of bond yields, causing a decline in bond prices.
Rising interest rates lead to higher bond yields, which in turn causes bond prices to fall. This is because the fixed coupon rate becomes less attractive compared to new bonds issued at higher rates, leading to a decrease in the market price of existing bonds.
The outlook for bond ETFs like IAF and VBND is positive in the long term. Current discounts are already priced in, and holding these ETFs to maturity will result in receiving the face value, which is higher than current prices. This, coupled with current yields, suggests a stronger outlook for fixed income.
If you hold bond ETFs that are underperforming, it might be wise to hold onto them. Fixed income will continue to provide a guaranteed yield, and current pricing is at a discount that will close as bonds mature. It could also be an opportunity to add to your positions and average down your price.
In a diversified investment portfolio, bonds are categorized as defensive assets. They provide stability and offset the volatility of growth assets like stocks. Ideally, bonds should offer uncorrelated returns, balancing out negative performance in other asset classes.
The current bond market situation is considered abnormal because the rapid recovery from the global pandemic led to inflation levels not seen in decades. This unexpected surge in inflation caught many, including global central banks, off guard, resulting in significant bond sell-offs.
Investors can benefit from the current bond market conditions by purchasing discounted fixed income securities. By holding these investments to maturity, they can receive the face value, which is higher than current market prices, and enjoy the higher yields available now.
When adding to fixed income positions, investors should consider the opportunity to average down their purchase price, gain a larger dividend from higher holdings, and take advantage of current discounts that will close as bonds mature. This strategy can enhance overall portfolio returns.
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