Bonds often take a back seat in the mindset of investors, who are instead focused on the fast-paced equities market and Australia’s long-standing obsession with property. However, this approach should be re-examined.
These are two asset classes Australians are traditionally significantly overweight in, so with US yields at a seven year high it should be time for investors to look at bonds.
After a long period of accommodative monetary policies, central banks around the world are now looking to increase their official cash rates. While some investors think rising rates are a reason to overlook bonds, it can actually be good news for bond investors, as when rates rise, bond yields rise. At 4 per cent, US high-quality corporate bond yields have reached a seven-year high and investors are taking notice of the attractive return.
This might sound counter-intuitive, as it’s generally known that bonds outperform when rates are falling and underperform when rates are rising. That’s certainly the case when you consider the typical government-type bond.
But bonds come in many shapes and sizes. In particular, selective high grade corporate bonds can deliver attractive income yields across the economic cycle. Bonds can complement investor portfolios by lowering volatility and can be tailored to match investors' differing time horizons and risk tolerances. And they have some other advantages. Investment grade corporate bonds offer a lower correlation to equity markets. Citi’s Strategists have found a correlation of 44 per cent to global equity markets in investment grade corporate paper, and that’s an advantage when building a resilient investment portfolio.
At Citi, we say bonds should be considered a strategic core of an investor’s portfolio and not an investment afterthought. How then, should an investor strategically use bonds to build their portfolio in this current climate?
There are a few key points to remember:
The duration of the bond is important, particularly in a rising interest rate environment. The longer the duration, the more the price of a bond will be affected by interest rate moves. However, investors can manage duration risk by seeking shorter duration exposures and a higher coupon rate, which gives higher capacity to absorb interest rate increases and maintain an acceptable yield.
The size of the global bond market ensures that investors have a wide choice when selecting bonds, so it is possible to combine high quality bonds with an attractive coupon. And a good market to scour for opportunity is the flourishing Kangaroo bond market, which is available for Australian dollar denominated bonds issued by offshore corporates and financials.
Moreover, they have been very resilient to rates volatility since the start of the year. At the end of 2017 and in early 2018, bluechips such as Vodafone, Middle-Eastern regional leading banks backed by their government entities, and also the French global leading banks were actively issuing bonds that provided opportunity for investors to diversify their portfolios. It is a market that increasingly has greater depth and choice.
In making your choice it is also important to consider the income part of a bond’s total return (commonly called the “carry”). It is a key component when building a bond portfolio. Coupons are the guaranteed regular income that an investor will receive provided the issuer does not default. Sticking with high quality bonds will ensure you are not taking on additional risk.
The other valuable metric an investor should consider is the “yield to maturity”, which is the return the investor will receive if the bond is held to maturity. It takes into account the bond’s purchase price and all the future coupon payments. Evaluating yield to maturity makes it easier for an investor to compare the returns of different bonds, particularly as there is considerable variance in bond prices.
Investors can also combine investments in both fixed rate bonds and floating rate bonds. Combining floating rate notes with fixed rate notes is adding a hedge against rising rates while lowering the overall portfolio interest rate risk. Floating rate bonds typically shine more in a rising rate environment as the coupons they pay is linked to a benchmark rate that is reset periodically. As such, the price of the bond is barely affected by a rise of interest rates and the duration risk is negligible, while the coupon received improves as the benchmark rate increases.
Amid geopolitical tensions, high-quality bonds act as a safe-haven for investors who look to maximise yields while minimising the volatility of their portfolios. Indeed, the regular coupon that bonds pay provides a buffer against volatility. Bonds also play an important role for Australian investors – who all too often limit their portfolios to shares and property: heightening portfolio risk and reducing the likelihood of producing consistent and regular income from a broader based investment strategy.
While US high-quality corporate bonds now offer the highest yields since 2011, bonds are still very much a compelling proposition for long-term investors, even when rates are rising. At Citi we help investors to select the most attractive opportunities to help them preserve their capital, receive regular income and hedge against market volatility.
Elsa Ouattara is fixed income specialist at Citi.
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