Accessing fixed interest markets

You can invest in fixed interest investments directly or through a managed fund. Managed funds provide a way of accessing a diversified portfolio of securities, which can include a mix of Australian or international government and corporate fixed interest investments or a combination of both.

With bond yields around record lows, the great returns from fixed-income investments may go in reverse if bond yields rise. This seemed to cause much consternation, with many seemingly thinking that “past returns are a good guide to future returns” and if bond yields rise surely that means higher returns from bonds.

Bond returns come from two sources: yield and capital growth when the yield changes.

For example, if the government issues a bond for say $100 and agrees to pay investors $5 a year interest in return then the initial yield is 5%.

If an investor buys the bond with a 5% yield and holds it until it matures the return will be 5%.

Hence the higher the yield the better.

However, in the short term, its value will vary inversely with the changes in the level of bond yields – as bond prices rise yields fall and vice versa.

Taking the $100 bond example, if the economy weakens and interest rates fall to say 4%, investors will snap up bonds paying 5% and in doing so this demand pushes up the bond’s price until the yield falls to 4%. This is effectively what’s been happening over the last few years as bond yields have fallen.

Of course, there are a lot more maths involved as the impact also depends on the maturity of the bond, ie how long it will take before the government has to pay investors back. This relates to what is called “duration”. The average duration of a typical Australian bond fund is around 4 years which means that each 1% fall in yields means a capital gain of 4%. However, if bond yields rise the effect goes in reverse, ie bond prices fall.

So the return an investor gets from bonds is made up of the yield (or income flow) they receive and in the short term any capital growth or loss if bond yields fall or rise. If the yield is just 3.5% a 1% rise in the yield to 4.5% would mean a capital loss of 4% and a total return over a year of -0.5%. If yields are unchanged the return will be just 3.5%.

Near record low bond yields

Down, down, prices are down, well, yields are anyway. Last year saw sovereign bond yields in the US, Australia, and other major countries fall to record lows, providing a strong capital boost to returns.

Because a bond yield is the earnings the bond generates each year divided by its value, turning it upside down gives a price to earnings ratio. As seen in the next chart this is extremely high, in fact, 49 times in the US and 28 times in Australia. If these sorts of price-earnings multiples applied to shares, it might be seen as a bubble.

It is exactly this environment that the basis of Shartru’s portfolio construction was born.

Are bonds in a bubble?

It’s never that simple. You know, it’s different this time. Which to some extent that is true. For one thing, interest payments on bonds are known with certainty whereas share earnings are less certain. But more importantly, both fundamental and bubble like elements have played a role in the bond rally. On the fundamental side, the sharp fall in bond yields from the early 1980s can be explained by the shift from high inflation to near no inflation. The more recent fall to record lows also reflects some fundamental factors.

  • Sub-par economic growth and low inflation in some key global markets have lowered equilibrium levels for interest rates and bond yields.
  • Various central banks have been actively buying bonds through quantitative easing, known in the 1970’s as an expansion of the money supply, or as a guy in Texas said by creating money the old-fashioned way, printing it!!!
  • Aging baby boomers in low yield equity dividend markets have invested in bonds seeking to get more yield into their portfolios.

Bubble, bubble, toil, and trouble – there are also some bubbly elements. In particular:

Huge inflows to US bond funds in recent years

Bond yields are well below sustainable levels