Globally, the world seems to be entering a period of slower growth. Volatility has been driving weaker sentiment, and the repercussions of trade wars have many questioning if we are entering a recession, or even a crisis, writes Mahjabeen Zaman.
Citi’s view is that we are not expecting a GFC-like situation going forward, in part due to the proactivity of central banks in their policy response. Locally, this has seen the Reserve Bank of Australia cut rates twice, with a further two forecast by Citi.
With the outlook for global growth expected to remain low, it is likely that central banks globally are looking to lower rates further. Monetary policy is often employed during recessions to stimulate demand by reducing rates in the banking system. However, much of its success is dependent on how responsive the private sector is to the decrease in rates, which means a level of uncertainty still prevails.
What does this mean for your investment portfolio?
The upshot for investors is that rates are going to be lower for longer. Lower rates mean it can be difficult for investors, particularly retirees and cash-only investors who may be dependent on interest income earned on deposits.
Many of these investors have been dependent on interest income from deposits, which has been reduced by at least 50 per cent, as we have seen rates move from 1.5 per cent to 1 per cent by the RBA, with a potential for this to be at 0.5 of a percentage point in 2020.
To combat this, investors are turning to bonds, including fixed income managed funds or ETFs, government bonds (US and Australian), investment grade and high-yield bonds. These products have seen a massive influx of flows over the past six months, from both retail and institutional investors. At Citi, we have seen the bond business grow by an exponential 300 per cent.
Investor flows into the fixed income asset class have been driven by two key factors.
Firstly, investors are trying to lock in yields before they move lower along with deposit rates. During an easing cycle, as demand into bonds increase, the prices of bonds move higher and bond yields move inversely: down. Bond yields are the rate of return on a bond, and are dependent on the price paid for it.
In January, AUD investment grade bonds yielded 5 per cent in January 2019. Today, AUD investment grade bond yields range between 3 per cent and 3.5 per cent. Australian government bonds (10-year) have seen a similar adjustment from yielding 2.3 per cent in January 2019 to 1.1 per cent per annum currently. If central banks cut rates further, more demand into these bonds will push bond prices higher and bond yields lower.
Secondly, bonds represent a “flight to safety”. Many investors are looking to lock in profits earned in equity markets from the longest bull run in history. Market consensus is that we are now at the late-stage cycle of this bull run, so clients are “de-risking” their portfolios and moving into more conservative asset classes like fixed income.
Which bonds are the right type of bonds?
Within the fixed income asset class, there are three distinct categories of bonds investors can consider:
1) Government Bonds – issued and backed by sovereigns, generally with AAA credit rating like Australian government bonds. These bonds carry low risk, and hence have relatively low return. For example, Australian 10-year government bonds currently pay 1.1 per cent per annum.
2) Investment Grade Corporate Bonds – issued by various corporates with credit ratings from AAA to BBB-. Within the Australian bond market, in 2019, there have been increasing issuance from global companies looking to raise debt in Australian dollars in order to diversify their funding needs which is largely in US dollars.
3) High-Yield Corporate Bonds – issued by corporates with lower credit ratings than investment grade bonds, i.e. BB+ to CCC. These bonds pay a higher return than investment grade bonds in order to compensate for the lower credit ratings/higher risk.
Within these categories, we have seen the largest inflows in investment grade bonds, as they are a balance between risk and return. Currently, AUD investment grade bonds pay a fixed yield between 3 per cent and 3.5 per cent per annum as opposed to deposit rates, which currently pay circa 2 per cent and are expected to move lower as RBA cuts rates in the coming months.
In the current market environment, the focus is more on the risk, and not as much as the return. By investing in AUD investment grade bonds, investors are locking in a pick-up in income over deposit rates. While the general term for a bond may range between five and 10 years, these bonds are liquid and can be sold on a daily basis.
Diversification within bond issuers is key. Investors can consider a mix of exposure to bond issuances for domestic and international corporates. Coupons per annum on these bonds range between 4 per cent and 5 per cent per annum. Through diversification, across various bonds, one can manage cash flows to match personal requirements.
With interest rates moving lower, investors can look to bonds as a solution for balancing risk against return.
Mahjabeen Zaman is a senior investment specialist at Citi.
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