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Market Update– Fixed Income

As share markets have fallen sharply recently due to concerns over rising inflation and rising interest rates the traditional ballast in a portfolio, fixed interest, hasn’t provided the protection that clients historically have been used to.

As share markets have fallen sharply recently due to concerns over rising inflation and rising interest rates the traditional ballast in a portfolio, fixed interest, hasn’t provided the protection that clients historically have been used to. During uncertain times like this the best outcomes for clients are often achieved by looking firmly ahead and taking a patient, measured and focused view of the future. 

Why have Bonds delivered a negative return? Central banks such as the Reserve Bank of Australia (RBA) have increased official cash rates in response to rising inflation. The increases in official cash rates elevate the cost of borrowing for a variety of things including mortgages and bonds.

What is the relationship of bond prices to interest rates? Bond prices move in opposite direction to changes in interest rates. Rates increase, bond prices fall and vice versa. The price of bonds over the last two years has moved lower to reflect the increase in borrowing costs (higher interest rates).

I thought Bonds went up when Equities went down? Historically in equity sell offs such as the Global Financial Crisis bonds did provide protection. Why? Because central banks reduced interest rates to stimulate economic activity and improve liquidity, this meant the market adjusted bond prices higher (capital gains for holders) as the prevailing interest rates were moved lower.

This time it’s different. In the current environment with inflation rising central banks are increasing cash rates to slow economic activity and reduce inflation. This is resulting in both bonds and equities selling off as bonds re-price lower to reflect the higher cash rate expectations. Equities have also sold off due to the waning of risk appetite as supply chain disruptions, Chinese COVID lock downs and the Russia-Ukraine conflict all add to investor uncertainty.

What happens next? With interest rates starting to rise and potentially continuing to do so some investors may be tempted to sell bonds. However, the rapid increase in interest rates (bond yields) has seen the relative attractiveness of investing in bonds improve.

The chart below shows the borrowing costs of the Australian Government from 0 year to 10 years and broadly reflects future expectations for inflation and resultant increases in cash rates into the future.

The recent reset higher in bond interest rates/yields is a good thing, notwithstanding the capital losses that have occurred. Now defensive assets are yielding an attractive income return – something that has not occurred for many years due to emergency central bank cash rate settings.

What about cash rates? Economists are predicting that the cash rate will be between 2-2.5% at the end of 2022 and will potentially peak at ~3%. This expectation of cash rate hikes is currently priced into bond markets. Therefore, if these expectations are met then you can expect bond prices to remain where they are currently all other things being equal. The caveat to this will be if inflation cannot be tamed and the RBA must raise cash rates more aggressively than markets currently anticipate. This could see bond prices fall lower.

What are Defensive Assets?

The terms Defensive Assets, Fixed Income and Bonds generally can be used interchangeably. This asset class is there to add ballast to a portfolio, cushion returns in equity sell offs, provide reliable income and be much less volatile than growth assets such as equities.

What is a Fixed Rate Bond? In simple terms a bond is an IOU from a borrower (a company or government) that in return for you giving them capital for an agreed period of time you receive a fixed amount of interest per year until the maturity date. Upon maturity the lender receives back their initial investment.

What is the amount of interest received? The interest that you receive is determined by three main factors:

  1. The prevailing interest rate
  2. The length of time until Generally, the longer the time frame the more interest would be required.
  3. How risky is the borrower? When lending money other than to federal governments, investors may require additional compensation for the risk of not receiving their money back. This additional compensation (expressed as a higher interest rate) is called the “credit spread”.

What is a Floating Rate Bond? A floating rate bond follows the same interest rate determination as per a fixed rate bond with one key difference: If interest rates rise the borrower pays the lender a higher amount of interest and vice versa.

Will defensive assets provide protection in the next market sell off? 

Yes, if we enter a low growth, low inflation environment central banks may then need to stimulate economies again and lower interest rates, remembering the bond prices move inversely to interest rates, resulting in capital appreciation for bonds.

Yes, if the current high level of inflation is tamed more quickly than anticipated bond yields will start to reflect lower expected future interest rates and therefore bond prices would likely increase.

It’s important to remember that now bonds are yielding a much higher income than they have in recent years. This extra income will help to offset any further capital losses should cash rates rise and therefore bond yields rise further from where the market is expecting them to rise to as of today.

What to do now? Whilst bonds have, in general, provided a negative return for investors over the last 2 years this isn’t a time to panic.

Higher interest rates are providing investors with a more robust return environment looking forward. As such, investors should look to the medium to longer term and understand fixed interest is part of a broader portfolio of assets and that being adequately diversified is part of attaining long term investment goals.

Important information 

This information has been produced by Australian Unity Personal Financial Services Ltd (‘AUPFS’) ABN 26 098 725 145, of 271 Spring Street, Melbourne, VIC 3000, AFSL. Any advice in this document is general advice only and does not take into account the objectives, financial situation or needs of any particular person. It does not represent legal, tax, or personal advice and should not be relied on as such. You should obtain financial advice relevant to your circumstances before making investment decisions. AUPFS is a registered tax (financial) adviser and any reference to tax advice contained in this document is incidental to the general financial advice it may contain. You should seek specialist advice from a tax professional to confirm the impact of this advice on your overall tax position. Nothing in this document represents an offer or solicitation in relation to securities or investments in any jurisdiction. Where a particular financial product is mentioned, you should consider the Product Disclosure Statement before making any decisions in relation to the product. A PDS can be obtained from your financial adviser or directly from the product issuer. We make no guarantees regarding future performance or in relation to any particular outcome. Past performance is not indicative of future performance. Whilst every care has been taken in the preparation of this information, it may not remain current after the date of publication and AUPFS and its related bodies corporate make no representation as to its accuracy or completeness. Published: June 2022 © Copyright 2021.

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