Fixed-income investors seeking safety in bonds be warned: it took only a relatively modest rise in bond yields over the past year for Australia’s headline bond index to post negative returns. This result highlights the risks that traditional fixed-rate bond investments currently pose to investors in an environment of low but rising bond yields. By contrast, floating rate bonds (FRBs) posted good returns over the past year, and appear well placed to outperform fixed rate bonds in a rising interest rate environment.
Higher bond yields leave Australian fixed-rate bond index investors exposed to losses
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, however, 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.
To explain why this is, let’s look at a simple example. Imagine a bond that promises to pay $5 at the end of a year plus a capital return at that time of $100. If the market demanded this bond provide a yield of 5%, the market value of that bond today would be worth $100. If, however, the market suddenly demanded that the yield on the bond increase to 7% (in other words if the market’s bond yields rose) – without the $5 interest payment changing – the only way this can take place is if the bond’s market value today drops to around $98, or a capital loss of 2%.
Given the nature of the fixed-income bonds in the BACI, estimates suggest a general 1% rise in bond yields would lower its capital return by around 5%, and vice versa.
Such a negative relationship between capital value and yields has been evident over the past year. This is because although the RBA left the official short-term cash rate on hold over the past year, the yield on Australian fixed-rate government bonds tended to rise – reflecting both reduced market expectations of further monetary policy easing in Australia and higher US bond yields.
Due to the rise in bond yields, the capital return from the BACI (and therefore passive products linked to this Index) declined by around 3% in the year to end-August 2017. This more than offset the BACI’s income return of 2.7%, resulting in a negative total return over this period of 0.7%.
Moreover, given the current annual income return from the BACI still remains fairly low, it would not take much of a rise in bond yields to produce further negative returns.
Floating rate bonds (FRBs) shine as interest rates rise
The price or capital value of floating rate bonds (FRBs), however, is much less sensitive to changes in the general level of market interest rates. That’s because, as the interest payments of these bonds are linked to a benchmark rate (such as, say, the Bank Bill Swap Rate), to a significant degree, the dollar value of interest payments these bonds pay adjusts or “floats” to reflect the prevailing level of short-term interest rates. Using the hypothetical example, if interest payments on the bond were allowed to rise to $7 (rather than the $5 fixed payment we spoke about earlier), the capital value of the bond would not need to decline below $100 to achieve the higher yield of 7%.
Accordingly, the index of senior bank FRBs (which is tracked by the BetaShares Australian Bank Senior Floating Rate Bond ETF – ASX Code: QPON) did not suffer any capital loss due to the general rise in bond yields over the past year. In fact, QPON’s index provided a total return of 3.8%, reflecting an income return of 2.7% plus some extra capital return due to a market re-rating of bank bonds generally.
The exhibit below shows the relatively wide variance in total returns for the year to end August 2017 from a range of bond indices.
Source: Bloomberg. * Solactive Australian Bank Senior FRB 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.
A rising interest rate environment should continue to favour floating over fixed rate bonds
Given the RBA has indicated that short-term interest rates are more likely to rise than fall looking ahead, and bond yields are also likely to rise, the BetaShares’ QPON ETF appears particularly well placed to potentially outperform the widely followed AusBond Composite Index (BACI).
After all, not only will QPON benefit from higher interest payments as and when the RBA lifts the cash rate, it should also not suffer the extent of potential capital losses BACI will be exposed to as bond yields rise.