There’s money to be made in turbulent times. Big moves in government bond yields don’t necessarily translate to big moves in corporate bond yields
Overseas bond markets are often early movers when investment conditions are changing so they are watched closely by large institutions and are the subject of intensive reporting and commentary.
These changes can be indicators to investors in much the same way as a lighthouse warns sailors to change direction, however, there are limits to their relevance that Australian investors should keep in mind.
In recent weeks, a strong signal has been received from European and US bond markets, with yields on German government bonds, known as Bunds rising dramatically from a very low base.
In April this year the 10 year Bund hit a low of 0.075 per cent , but since then yields have skyrocketed around ten times to be 0.80 per cent, however still less than 1 per cent for ten year money.
The very rapid, steep rise was a shock to markets. The movement would mean a significant paper loss to investors who bought the bonds at the low point, with the price of the fixed rate bonds declining as yields rose.
The correction was in part due to better than expected economic conditions, not warranting a pessimistic outlook. The lower yields get the more risky they become, as even slight changes can have dramatic effects when yields are so low.
If you think about it, shares can act in a similar manner. The higher that prices get (without the support of fundamentals) the more risky they become and the greater the chance of a correction.
The widespread reporting of these movements in overseas markets has alarmed many local investors but the translation to Australian government bonds and corporate bonds is not as strong as they might imagine.
For a start, our Commonwealth Government bond yields have not reached the impossibly low levels of Bunds or the very low levels of US government bonds known as Treasuries. Ten year Australian government bonds hit a low of 2.28 per cent on 3 February and again on 15 April 2015, but have since risen to close at 2.98 per cent on Wednesday 17 June 2015, rising by 0.70 per cent. That’s a big percentage increase jump, but nowhere near the Bunds. US 10 year Treasuries hit a low of 1.64 per cent on 30 January 2015 and rebounded to 2.31 per cent on 17 June, a 0.67 per cent shift, but the percentage increase based on the lower initial yield would be higher than the Australian bonds. The point to note is that the impact is greater the lower the yield is to start.
If we look at corporate bonds, the proportional movements have been minor when compared to government bonds given their higher overall yields. Bloomberg’s AusBond Master 0+ Index tracks a variety of bonds: fixed, floating and inflation linked as well as “other”. This index, which shows returns on a basket of bonds - so a higher number is better - peaked on 15 April 2015 at 2,657 and declined just 2 per cent to 2603 on 17 June 2015.
This tells us something about the Australian market as those bonds with higher yields will not show the same percentage swings when interest rates rise compared to the lowest risk government bonds.
Commentators often refer to US Treasuries when they are discussing bonds. While the yields on these bonds do impact our market, they behave differently to corporate bonds.
The main message for individual investors here is not to be put off by general bond commentary; it’s currently mostly about US Treasuries and German Bunds. Corporate bonds behave differently to government bonds, higher yields somewhat protect investors in a fluctuating interest rate environment.
A little bit of volatility can be positive, identifying when the swings have overshot is where there is money to be made.