Recent market concerns with regard to rising bond yields has once again drawn attention to the value of floating versus fixed rate bonds in such an environment. This note provides an update on the recent performance of these two types of bond exposure.
Risk and Return in Fixed vs Floating Bond Exposures
As I’ve previously explained, the headline bond index in Australia – against which many active and passive bond funds benchmark themselves – is the Bloomberg AusBond Composite Index (BACI). One challenge with this Index is that it is dominated by fixed-rate government and corporate bonds, which means its capital return is highly sensitive to the changes in the general level of bond yields.
By contrast, the price or capital value of floating rate bonds (FRBs) is much less sensitive to changes in the general level of market interest rates. To provide a degree of insulation against such interest rate risk, the BetaShares Australian Bank Senior Floating Rate Bond ETF (ASX Code: QPON) tracks an index comprising only senior bank floating rate bonds.
As seen in the table below, the upshot of these differences is that while the average time to maturity of bonds in QPON’s Index is only moderately lower than that of the BACI (4.2 years versus 6.2 years), the former’s effective duration – or interest rate sensitivity – is considerably lower (0.1 vs 5.2). This means that while a 1% rise in the general level of interest rates would reduce returns from QPON’s Index by 0.1% over a given time period, the decline in the BACI would be around 5.2% – and vice versa.
Source: Bloomberg. QPON’s Index is the Solactive Australian Bank Senior Floating Rate Bond Index.You cannot invest directly in an Index, and figures shown do not include QPON’s fees and expenses. Inception date of QPON’s Index is 30 May 2017 and data prior to this date has been simulated and may not be reflective of actual results. Past performance whether simulated or actual is not indicative of future performance.
It’s no surprise therefore that the volatility of returns from the BACI has also been higher than that of QPON’s Index in recent years (2.9% vs 0.9%). Note, moreover, that the BACI is not presently offering much of a yield advantage over QPON’s Index (a yield-to-maturity of 2.6% versus 2.5%) in exchange for its heightened interest rate risk.
Recent Bond Performance
The chart below details trends in the annual return performance of the BACI, QPON’s Index and the Bloomberg Bank Bill Index (which tracks shorter-term funding bills issued by banks). As is evident, bank bills offer the least volatile returns over time, followed by QPON’s Index and then the BACI. Indeed, the BACI’s returns tend to fluctuate significantly in line with changes in the general level of interest rates over time.
* Solactive Australian Bank Senior Floating Rate Bond Index. You cannot invest directly in an Index, and total return figures shown do not include QPON’s fees and expenses. Inception date of QPON’s Index is 30 May 2017 and data prior to this date has been simulated and may not be reflective of actual results. Past performance whether simulated or actual is not indicative of future performance.
Over the past year, 12-monthly returns from QPON’s Index have remained close to around 4%, whereas those from the BACI have fluctuated widely – from a loss of 0.75% in the 12-months to end-September 2017, to a high of 4% in the 12-months to end-November 2017. In the 12-months to end-January 2018, QPON’s index returned 4% compared with 2.75% for the BACI.
Given these results and continued concerns over rising bond yields, we are seeing a number of investors considering our QPON ETF as a core Australian bond allocation for their portfolios.