For the last few years, we have been well-acquainted with the ‘lower for longer’ interest rate environment. As a result, many investors have turned their backs on fixed income assets in search of investments offering a higher yield.
Times are changing. The cash rate has turned around from a low of 0.10% to 1.35% at the time of publishing with several increases expected throughout the year and a current market expectation of around 3% by year-end1.
Meanwhile, sharemarkets globally have experienced major downturns.
These market conditions have raised the question: is fixed income back in vogue?
The inverse relationship
Bonds are perhaps the most commonly known investment within the fixed income asset class.
By investing in a bond, you are lending money to an entity like a company or government in exchange. Generally, you’ll receive regular interest payments known as coupons, in addition to the repayment of the bond’s face value at maturity.
By raising interest rates, the Reserve Bank of Australia is attempting to combat higher inflation, which surged 5.1% over the 12 months to March-end and is evidenced by the sudden rise in petrol and food prices.
It is important to understand that bond prices and bond yields move in opposite directions, while bond yields are influenced by interest rate expectations. As a result, rising interest rates generally lead to falling bond prices and falling interest rates lead to rising bond prices.
Yield is a measure of the bond’s internal rate of return and is usually quoted as a percentage per annum. It takes into account both the income the bond pays (the coupon) and the difference between the current market price and the face value of the bond that will be repaid at maturity.
For example, the Australia 10 Year Government Bond yield is currently sitting at around 3.5% at the time of publishing and the US Treasury 10-year Note yield at 2.95%, up from lows of 0.5% and 0.3% in March 2020 respectively.
The below charts show how interest rates have evolved over the past three decades, including the recent rises.
Source: Reserve Bank of Australia/BetaShares
How does fixed income fit in your portfolio?
Fixed-income ETFs allow you to invest in a portfolio of bonds.
In the current inflationary environment, the real value of cash is going backwards. Banks are passing on interest rate rises to investors at least in part, and some are offering savings accounts with 2% returns – yet with inflation at ~5% the real return is around negative 3%.
Investment-grade corporate and government bonds offer yields above the cash rate, and tend to be negatively correlated with shares.2
Some benefits include:
- Regular and reliable income often at lower levels of risk than other assets such as equities or property
- Portfolio diversification by helping to reduce overall risk and provide defence for an investment portfolio during sharemarket declines
- Capital stability and preservation, as the holder of a bond expects to be repaid the face value of the bond at maturity.
BetaShares offers a range of fixed income ETFs including:
- Australian Bank Senior Floating Rate Bond ETF (ASX: QPON)
- Australian Government Bond ETF (ASX: AGVT)
- Australian Investment Grade Corporate Bond ETF (ASX: CRED)
- Global Government Bond 20+ Year ETF – Currency Hedged (ASX: GGOV)
- Australian Composite Bond ETF (ASX: OZBD)
- Sustainability Leaders Diversified Bond ETF – Currency Hedged (ASX: GBND)
- BetaShares Western Asset Australian Bond Fund (managed fund) (ASX: BNDS)
The below chart sets out the current yields on BetaShares’ fixed income ETFs (bearing in mind the RBA’s current cash rate is 1.35%).
*All in yield is the total yield offered at current market rates. It consists of a benchmark rate (The Bank Bill Swap Rate, BBSW in short for AUD Floating Rate Notes) that moves up or down with market interest rates, and a ‘discount margin’, a spread over and above the reference rate, which is specific to each security and relates to the risk level of that security.
The yields offered by fixed income ETFs are higher than they have been in a long time. Economists and markets remain divided on where rates will go from here. But the wide range of fixed income ETFs on offer allow investors to prepare for many different outcomes.
Perhaps now is the time to consider adding fixed income ETFs as a part of a well-diversified portfolio.
Investment risks associated with fixed income ETFs may include for example interest rate, credit and market risk. For more information on risks and other features of the ETF, please see the respective Product Disclosure Statement.
1. ASX. “ASX 30 Day Interchange Cash Rate Futures Implied Yield Curve.” ASX, 6 July 2022, www.asx.com.au/data/trt/ib_expectation_curve_graph.pdf.
2. Ewan Rankin and Muhummed Shah Idil. “A Century of Stock-Bond Correlations.” RBA Bulletin, 2014, pp. 67–74, www.rba.gov.au/publications/bulletin/2014/sep/pdf/bu-0914-8.pdf.