Are rising rates really bad news for fixed-rate bonds? Maybe not. | BetaShares

Are rising rates really bad news for fixed-rate bonds? Maybe not.

BY David Bassanese | 11 July 2018
Share
What impact does rising rates have on fixed-rate bond returns?

Assuming an easing in current global trade war concerns, it still seems likely that global long-term bond yields will rise rather than fall somewhat over the next year or so. This note examines the likely impact on fixed-income bond returns, and the degree to which the prospect of higher rates can already be “priced” into the market.

Long-term bond yields – a return to normal still some time away

As seen in the chart below, long-term bond yields in Australia have lifted somewhat from the low of mid-2016 – largely due to higher rates in major industrial economies such as the United States, as central banks have started to gradually withdraw policy stimulus. That said, bond yields still remain somewhat lower than the average prior to the global financial crisis, and further gains seem likely especially if the Reserve Bank eventually moves to lift local short-term interest rates also.

 

How susceptible are fixed-income returns to rising yields?

At face-value, rising bond yields are not great news for holders of fixed-rate bonds. After all, higher market interest rates tend to reduce the market value of fixed rate bonds, because their future stream of fixed nominal interest payments are worth less in today’s dollars.  The key measure of this price sensitivity to interest rates is known as the modified duration, which in turn is related to the remaining term-to-maturity of the bonds in question.

For example, one of the most commonly used bond benchmarks for local fund managers and Australian Bond ETFs is the Bloomberg AusBond Composite Index (BACI).  The BACI is weighted by bonds on issue in the Australian market and as such has around a 90% weight to Government bonds and 10% weight to corporate bonds and an overall modified duration of 5.2 years as at end-May 2018.   This implies that a 1 percentage point increase in the general level of market interest rates that applied to bonds in this Index would overall lower the market value of bonds in the Index by 5.2%.

So far so bad – but there are three countervailing points worth considering.

  • To the extent long duration fixed-rate bonds usually offer higher yields than shorter duration bonds and cash, investors are being compensated to a degree for the decline in market values should interest rates rise.  For example, if the BACI offered a 1% higher income return over the coming year than cash, then its annual return would still be better than cash for any lift in bond yields of less than around 20 odd basis points over this period (0.2% times 5.2 modified duration equals a 1.04% loss in capital value).
  • The longer it takes for bond yields to rise, the slower the drag on bond values over any given period, and the more likely their yield returns in this period will keep overall returns positive.
  • While a lift in bond yields hurts the value of existing bonds held, it does result in higher income returns over time as and when new bonds are purchased that now offer higher yields.

As seen in the chart below, for example, the BACI has experienced periods – typically when bond yields are rising – in which returns under perform that available from cash, as proxied by 1-month bank term deposits*.  But these periods of under performance have tended to be brief, and have been soon recouped from the higher income returns that long-duration bonds tend to offer over term deposits.

Source: Bloomberg. Past performance is not an indicator of future performance. You cannot invest directly in an Index.

The BetaShares Investment Grade Corporate Bond ETF (CRED)

We can take this analysis further by considering returns from the index used in the BetaShares Investment Grade Corporate Bond ETF (ASX Code: CRED).  Compared to the BACI, the Index which CRED aims to track provides exposure to bonds which are generally longer in duration and only from the corporate sector (i.e. it excludes lower-yielding government bonds).  As a result, CRED’s Index should typically offer a higher yield than that available on the BACI, albeit with greater price sensitivity to changes in the general level of interest rates and corporate credit spreads over time. Indeed, the modified duration for CRED’s Index as at end-May 2018 was 6.5 years.  CRED’s Index yield-to-maturity as at end-May was 4% p.a. compared to only 2.6% p.a. for the BACI.

How have these generally higher income returns but greater price sensitivity to market conditions affected the relative returns of CRED’s Index over time?  As seen in the chart below, the returns of CRED’s Index have generally been stronger than that of the BACI since early 2008, which can be partly attributable to the trend decline in bond yields over this period.  That said, even in the period of relatively steady bond yields over the past year or so, CRED’s Index has still outperformed the BACI, due to the generally higher yield it offers.

Note, moreover, that while there have been periods in which CRED’s Index has under performed the BACI, such periods have tended to be relatively brief and quickly recouped from the relatively higher yields offered by bonds in CRED’s Index.

Source: Bloomberg. Past performance is not an indicator of future performance. You cannot invest directly in an Index.

All up, while bond price returns will tend to be reduced as and when bond yield rise, overall returns will be supported to some extent by the generally higher income they offer – especially compared to more capital stable assets such as cash. From a longer-term perspective, moreover, higher bond yields are good news for investors in long-dated fixed-rate bonds as income returns will tend to increase over time.

These features are even more evident when higher yielding fixed-rate bond exposures such as the CRED ETF are considered. Over time, CRED’s Index has historically outperformed the commonly used AusBond Composite Index with only relatively brief periods of under performance when bond yield have risen and/or credit spreads have widened.

 

 

 

*Monthly term deposits rates sourced from the Reserve Bank of Australia, which is based on the average rate offered by Australia’s 5 largest banks.

 

Leave a Reply