Introduction

The Lowdown on BondsBy Sam Hunt

Here’s a rare financial market prediction. At some stage, either this year or next, The Australian Financial Review is going to splash across its front page the headline ‘RBA Lifts Rates for First Time Since 2010’. But guess what? It won’t be news to the market.

The Lowdown on Bonds By Sam Hunt

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Speculation about rising interest rates has been rife since Australia’s official cash rate – the interest rate which banks pay to borrow from other banks on an overnight basis – hit an historic low of 0.1% (virtually zero) in November 2020.

Australia wasn’t alone in slashing rates to zip. The US Federal Reserve, the equivalent of the RBA, cut its key rate to zero when markets tanked in March 2020 as the first wave of the pandemic hit.  The Bank of England did the same, as did other major central banks.

Sure enough, with that massive sugar-hit flowing through the veins of the global economy last year, and governments spending up big to offset the hit to activity from shutdowns, demand started to take off again. So far, so good.

The problem was that supply chains had been disrupted by the pandemic. In many cases, ports had been shut down, production had been curtailed and there were logjams in getting goods to warehouses and onto consumers.

Now, Economics 101 tells you that when you get a big kick-up in demand without a commensurate increase in supply, the result is a spike in inflation. And that’s exactly what we’ve seen. In the US, inflation has hit its highest levels in nearly 40 years. In Australia, while it’s not as bad as that, core inflation still hit a seven-year high in the December quarter.

Even so, the inflation surge has caught markets off guard and led them to project four US rate hikes this year and a similar number in Australia, despite the RBA’s protestations that it is unlikely to start tightening the screws here until 2023. At time of writing, the 30-day interbank cash rate futures contract, traded on the ASX, points to the cash rate at 1.5% by mid-2023.

But there’s something else you need to know about interest rates. There are literally hundreds of them! What’s more, the markets set the vast majority of them. In fact, the markets move well ahead of central banks, as we saw last October when the RBA was forced to ditch its program of keeping the price of borrowing out to three years at the same level as the cash rate.

The reversal of these market interest rates –“bond yields” – led to the global bond market last year experiencing its first year of negative returns in Aussie dollar terms since 1994. Rising bond yields means falling bond prices. So if you held a diversified global portfolio of government and corporate bonds last year, you suffered a negative return of about 1.5%.

Of course, this leads people to ask: “Hey, this can’t be right! Aren’t bonds supposed to be the defensive part of my portfolio? Why am I losing money on them?”

The answer is that bonds, like shares, are still risky assets. There are two key risks with bonds. The first is term risk. Longer-term bonds are more sensitive to inflation. This is what we saw in 2021. The second risk is credit risk. That’s the risk of the borrower defaulting on the loan.

But even taking those risks into account, bonds are much less volatile than shares because the future cash flows from their coupon payments (unlike dividends from shares) are known. As we said, bonds have had only one negative year in three decades. Plus, they tend to behave differently – zigging when shares zag. This chart shows you that pattern.

So last year, for instance, global developed market shares returned about 30%, which given what’s going on in the world was pretty impressive. In other years, when shares have been smashed, bonds limited the damage. In 2008, for instance, Aussie shares fell nearly 40%, but the global bond market rallied about 10%.

So bonds act as a sort of buffer, or a shield to the sword that is your equity allocation.  But they’re not risk-free. If you want risk-free, you have cash. But, as we know, cash rates are close to zero. And if you need to grow your capital, that’s not really a risk-free option at all.

The alternative to sheltering completely in cash is to hold a diversified portfolio, containing global and local stocks, global and local bonds, listed property, as well as cash in reserve. How much of each you hold will depend on a whole host of variables, like your risk appetite, your other assets, your age and your goals.

What happens with interest rates going forward is going to depend on the news on inflation, growth and other economic numbers. If inflation turns out to be not as bad as the market has priced already, you’d expect market rates (yields) to fall and bond prices to rise. If inflation exceeds expectations, you’d expect the opposite.

The way to deal with this uncertainty in your bond portfolio, as in your share portfolio, is to diversify – across different maturities, across government and corporate bonds and across different currencies – in line, of course, with your risk appetite and goals.

As for central banks, the media may get excited about the announcements. But most of the time, the market has already moved ahead of them. It’s yesterday’s news.

And that is the lowdown on bonds.

Sam Hunt

Sam Hunt - "I have a genuine desire to help our clients achieve what is most important to them, by giving them clarity around the important financial decisions they face."