With the Cash Rate jumping 2.5% since April, owners of assets are certainly starting to feel the pain in their balance sheets as valuations adjust. Those using leverage (debt) are also feeling it in their cashflows, as the cost of servicing increases. Although, this is somewhat ameliorated by inflation eroding the real principal value (ie. the dollars borrowed are worth more than the dollars repaid).
Interest bearing securities, such as bonds, ordinarily provide a defensive shelter from corrections in shares and property. However, this time they too have suffered a substantial correction. Indeed, the benchmark 10yr US Treasury Bonds are on track for their worst year ever! Since the Great Depression, there have only been 4 other years in which shares and bonds have suffered negative returns in the same year.
Why? Essentially because interest rates have been at record lows since the GFC and extremely so during the Covid pandemic. As economies came out of lockdowns, households and businesses were flush with cash and ready to party. The problem is supply was constrained by disruptions in the global supply chain caused by Covid and the Ukraine conflict. What happens when demand exceeds supply? Prices rise. This is inflation. As prices rise, workers demand higher wages and a doom loop called a wage-price spiral can begin. To stop this, central banks (e.g The Federal Reserve and RBA) have slammed the brakes on the economy to shock us out of this doom loop. While this hurts us all, the pain of prolonged inflation would hurt more.
As we expressed in our last newsletter, it is anyone’s guess as to when this cycle of inflation and rising rates will end and we do not pretend to have a crystal ball. However, you don’t need a crystal ball to invest effectively. We focus on looking at long-term valuations and balancing downside risks against upside risks based on available data. We don’t look to pick the bottom, but acquire assets at reasonable prices over time and hold them for the long-term as part of a diversified portfolio.
While our view is that, despite the substantial correction, the downside risks for shares and property continue to outweigh the upside risks, we think fixed rate bonds do represent reasonable value for the first time in decades. Why? First, lets understand what a bond is and how it behaves.
What is a bond?
A bond is essentially an IOU issued by a company for a loan at a rate of interest (called the coupon) repayable in full on a certain date (maturity). Like a mortgage, the interest rate can either be fixed or variable. However, traditionally the rate is fixed. Hence, bonds are often referred to as “Fixed Interest” or “Fixed Income” securities.
Bonds can be bought and sold on the open market. The price of a bond will move depending on movements in the issuer’s credit risk and interest rates.
Like any debt, the lender (or owner of the bond) is exposed to credit risk of the issuer ie. the risk of the issuer failing to repay. This risk is generally greater the longer the term (more time for things to go wrong) and the higher the coupon (harder to pay).
As we are currently experiencing, interest rates move up and down over time. Because most bonds offer a fixed rate, the price of the bond adjusts inversely to interest rate movements. For example, if I lend you $1,000 at 5% for 10yrs and next year market rates for 10yr bonds move to 6%, your bond becomes less attractive to buyers. To sell it, I would have to offer your bond at a price below its face value (a discount) such that a buyer would receive a 6% yield. If, on the other hand, rates went down, I could command a premium.
So, with interest rates at record lows for decades, you can now see why we have limited our clients exposure to traditional fixed interest bonds through this period: super low rates equal super high bond prices. The downside risk (ie. rates rising at some point) outweighed the meagre yields on offer. Instead, we used floating rate bonds which have limited “duration” risk (sensitivity to interest rates) to provide you with a defence against growth assets correcting and, for the retirees, liquidity to draw on for income.
However, with 10yr bond prices correcting over 15% and the probable peak in interest rates priced in, we think a diversified portfolio of investment grade (blue chip) Australian bonds presents reasonable value with yields of 4-6% . As the likelihood of a recession increases and with it an end to rate rises, the downside risks decrease. But they do not disappear: if rates go higher than currently expected, these yields will be eroded. So, accumulating over time makes sense.
We will be contacting our clients in the coming weeks to discuss whether adding this sort of bond exposure to their portfolios is appropriate.
For those with mortgages, as rates rise, valuations drop and lending policies tighten, it is more important than ever that you keep the cost of your debt as low as possible and ensure it is structured appropriately. In particular, those still on low fixed rates should beware as the loan reverts to a variable rate, as that rate is likely to be much higher than current market rates.
While your mortgage can’t be traded in the same way as a bond, it is now much simpler to refinance and our expert mortgage brokers will help you canvass the over 40 mortgage lenders in the market for the best possible deal. The mortgage lending market is highly competitive and that level of competition increases as margins (the gap between deposit and mortgage rates) widen. So, make sure you take full advantage!
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Disclaimer: The information and articles in this newsletter are of a general nature only and are not to be taken as recommendations as they might be unsuited to your specific circumstances. The contents herein do not take into account the investment objectives, financial situation or particular needs of any person and should not be used as the basis for making any financial or other decisions.