This time last year, all financial asset prices were propped up following the enormous amount of stimulus being provided by central banks via dropping policy rates to record lows and quantitative easing. It was also around this time the market was considering rates after, Fed Chair Jerome Powell told the Senate Banking Committee “it's probably a good time to retire that word (transitory),” persistent inflation was no longer going to be ignored.

What followed was the sharpest central bank hiking cycle in many decades and quantitative tightening. Asset classes that rode the wave up, were correlated on the way down. The impact on bond prices has been unprecedented. Prices have fallen so far, income can once again play a significant role in total bond returns. 

In addition to falling bond prices, credit spreads have widened too. This is a new world and it has created opportunities, especially in credit.

Bonds are back, but being selective is important.

Coming into 2022, all financial asset prices were elevated following the enormous amount of stimulus being provided by central banks via dropping policy rates to record lows and quantitative easing. However, what surfaced was the realisation that high inflation prints were persistent not transitory which required the sharpest central bank hiking cycle in many decades and quantitative tightening to contain inflation. The fallout saw many asset classes, that were highly correlated on the way up, remain highly correlated on the way down.

Making the problem more acute for bond investors, who a couple of decades ago could rely on reasonable current income to mitigate price losses when yields were rising, quickly discovered in this environment, that current income was too low to provide a ‘carry cushion’ in mitigating unprecedented price falls.

The ‘carry cushion’ quantifies how much yields relative to duration can increase before a bond investment return over a 12-month period becomes negative.

At the start of the year when Australian 10-year government bonds were yielding 1.60% (as of 31 December 2021), not only was the current income negligible, it was only enough to absorb a 0.18% rise in yield over the next 12 months before an investor was underwater on a total return basis.

Needless to say, the rises in yields and spreads over the past 12 months have been higher by several orders of magnitude, and capital losses have therefore been severe. The Australian Government Bond 10 Year more than doubled to 3.53%, Australian credit spreads widened to above COVID-19 highs and this has been reflected in the returns of Australian corporate bonds.

Australia’s corporate bond benchmark, the Bloomberg AusBond Credit 0+ Yr Index (AusBond Corporate) has suffered a maximum drawdown beyond 9%, its biggest ever fall, well beyond the falls of the 1994 bond crash.

Chart 1: Drawdown of Australian Corporate bonds
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Source: Bloomberg, data to 30 November 2022. You cannot invest in an index.  Past performance is not a reliable indicator of future performance.

Chart 2: Credit Spreads of Australian Corporate bonds
carry-on-bonds-2.png
Source: Bloomberg, data to 30 November 2022. You cannot invest in an index.  Past performance is not a reliable indicator of future performance.

The silver lining, is that now the yield on bonds is closer to, or in some instances higher, than the rates at the long end of the curve. Another positive is that the price of incremental risk in some fixed income markets has de-compressed. More specifically, as credit spreads have also widened, there is greater magnitude for income the further out the credit risk curve.

The combination of wide spreads and fallen prices means that ‘carry’ is once again providing fixed income investors a cushion. The income earned on the current 10-year Australian Government bond note provides a return buffer that would allow investors to break even, even if the yield increases by 37 bps to 3.90% over the next year. For corporate bonds, the carry is higher. The yield at which investors in VanEck Australian Corporate Bond Plus ETF (PLUS) would break even in 12-months’ time is about 6.75%, or 115 basis points above where it stands today. In other words, yields would have to rise over 1% in the next twelve months for the total return of PLUS to be below zero.

Chart 3: The higher carry provides greater cushion against higher yields

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Source: Bloomberg, S&P, as at 30 November 2022.

Another positive going into 2023 is that broker consensus is for the Australian government 10 year government bond yields to remain at similar levels over the next 24 months. The global economy is expected to slow as consumers and business slow spending in the face of higher interest rates. The futures market also expect the Federal Reserve and RBA to cut respective policy rates in H2 2023.

Chart 4: Australian government 10 year bond yield median broker forecast
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Source: Bloomberg, As at 7 December 2022.

With equity markets in a state of flux, now could be the time for investors to reallocate back to bonds. Bonds are back and one way to gain access to a portfolio of the highest yielding investment grade corporate bonds is via PLUS.

PLUS: Investment-grade, short dated over long dated securities

The VanEck Australian Corporate Bond Plus ETF (PLUS) provides a diversified and higher yielding investment-grade credit exposure relative to the Bloomberg AusBond Corporate Index.

PLUS is yielding 5.60% as at 30 November compared to 4.78% for the Bloomberg AusBond Credit 0+ Yr Index. Noting past performance is not by no means an indication of future performance. 

Fund characteristics:

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Source: VanEck, Markit, Bloomberg; as at 30 November 2022. Past performance is not indicative of future performance. 


Key risks

An investment in PLUS carries risks associated with: bond markets generally, interest rate movements, issuer default, credit ratings, fund operations, liquidity and tracking an index. See the PDS for details.

Published: 15 December 2022

Any views expressed are opinions of the author at the time of writing and is not a recommendation to act.

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