What next for the bond market?

With the ending of the US quantitative easing program, and the Reserve Bank’s move away from its easing bias after rates have fallen to an all-time low, apprehension about rising rates may cause some investors to shy away from bond investing. 

The consequences of the inverse relationship between bond yields and price is that, in a rising interest rates environment, bond prices will fall and there will be a capital loss for those invested.  But investors should not shun bond investing because, as a general rule, the higher yield will offset the capital loss rising from a rise in interest rates. Over a period of time, the total return from bonds can be quite attractive. 

So what is the likely outcome for the performance of bonds in a rising rate environment?  The US evidence from 1966 to 1981 saw the five-year Treasury bond triple – and that period was one of worst times for US bonds.  But, according to Ibbotson Associates’ data, a portfolio of intermediate-term US government bonds with five-year maturities produced a 5.8% annualised return during that period.

Australia’s bond market history has seen similarly bad times, with a spike in interest rates in the 1990s causing the UBS Composite Bond Index to fall nearly 5% – although the fall in the sharemarket was almost double.  But, from 1995 until 1998, the total return from the same index was positive. In fact, in 1995 the return for bonds was almost 20%, followed by returns of above 10% for the next few years.  The one-off capital loss in 1994 from the major move in interest rates was more than offset as the impact of higher interest rates kicked in and, as bonds matured in the benchmark, the proceeds were reinvested at the higher interest rate.

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Although investors are familiar with shares and their accompanying volatility, they tend to be less familiar with bonds and maybe fearful of losses in their bond holdings if interest rates rise. 

The above-average returns bond investors have experienced following the 2008 financial crisis led to unrealistic expectations about bond returns. The strong returns were predominantly from capital gains, with a minimal contribution from yields.  Going forward, the traditional role of bonds in providing income and capital stability will become integral to bond investing. 

Shares vs bonds

A portfolio of shares may have the ability to produce greater future capital returns, but the volatility of shares is always going to be greater due to the nature of the sharemarket relative to the bond market. Investors that are members of SMSFs, especially those close to retirement age, need to be more mindful of the value of their investments.  Bonds can provide protection against the capital value of an investor’s portfolio from movements in sharemarkets, as well as contributing a steady income stream.

The dynamics of the bond market and sharemarket are quite different and contribute to the role of bonds as a stabilising influence in a portfolio.  The monthly total returns for bonds are tightly distributed around the benchmark relative to shares and are less variable over time.  In other words, the volatility of shares has been almost four times the volatility of bonds over the long term (figure 1).  The regular, known cash flows from bonds and ranking of bonds before shares in a winding up of a company, contribute to the way bonds behave relative to shares, and increase the attractiveness of holding a weighting in bonds in a portfolio that is diversified across other asset classes such as shares, property and cash.

Because the RBA introduced inflation targeting with the aim of maintaining inflation within a band of 2-3%, the massive interest rate shock of the 1990s, with large upwards moves in rates, is unlikely to be repeated in Australia.  If we are at the start of a cycle of rising interest rates, the actions of the RBA are likely to act as shock absorbers – and the moves in interest rates will be more incremental than any large one-off hits like we saw in 1994, when rates rose significantly higher in a short period of time.

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Bond market investors should view rising rates as a positive medium- to longer-term outcome for bond investments.  The implications for investors are that, if they believe a rise in interest rates is likely, then a bond investment with shorter maturity will facilitate their view. 

The duration of the investment determines the impact on the bond investment by changes in interest rates.  The higher the duration (the longer the maturities of the bonds) the larger the impact on the capital return when rates change.  So a shorter-dated bond investment will provide less pain in the event of rate rises with the benefit of the higher yield influencing the portfolio earlier.  But the difficulty with forecasting the timing and magnitude of interest rate rises is evident by the opposing views on this topic shared by the investment community. 

The opportunity cost of moving into cash or shorter-dated maturities may offset the prevention of any financial loss from a rate rise but inadvertently expose the investor to other risks such as unforeseen changes in the yield curve (long rates may fall while short rates rise) or reinvestment risk (timely reinvesting to capture the changes in yield).

Preparing for higher rates

Among the ways investors can prepare for a rise in interest rates is to invest in a portfolio of bonds that meets their objectives with respect to:   

• The investment period required. If the capital is likely to be needed within a year then a better option may be term deposits.
• The yield that an investor needs to meet cash requirements.
• The level of risk an investor can tolerate, as holding a diversified selection of bonds from different issuers, with varying maturities and yields, may reduce the size of one-off losses from rate rises.