As published in The Australian on 6 September 2016
There is a string of Australian commentators, who do not even understand bonds, suggesting that there is a bond bubble
They appear to be mimicking US commentators whose comments relate to US government fixed rate bonds. In that context, I agree there is scope to describe the market as in a “bubble”. These bonds known as US treasuries have very low yields with three year bonds returning 0.96 percent and ten year, 1.62 percent. If the US Fed increases interest rates, these bonds will lose value.
Would they burst? It’s unlikely for a number of reasons. First they have maturity dates, so no matter what happens to the price of the traded bond, investors can hold onto the bonds until maturity and get the face value of the bond plus interest back. So investors have the certainty of a maturity date and in the case of US treasuries, the US government prints the currency and that is why its bonds are still regarded as ‘safe haven’ assets.
A typical ‘bubble’ occurs when assets become grossly over valued. In the case of shares, when the bubble bursts, share prices fall dramatically. Some parts of the bond market may have excessive valuations but for prices to fall dramatically in a bubble scenario, interest rates would need to go up quickly and unexpectedly. I don’t think anyone expects that.
So, when I read an Australian financial commentator espousing US style rhetoric, my first thought is that they just don’t understand the market, and here are a few reasons why:
- Just like property, where there are a range of markets – residential, commercial and industrial, there is also a range of markets for bonds.
Various bond markets include: investment grade, sub investment grade also known as high yield, corporate bonds, foreign currency, Residential Mortgage Back Securities (RMBS), sovereign or government bonds such as US Treasuries or Australian Commonwealth government bonds.
The Australian corporate bond market is a different prospect to US treasuries. Current investment grade corporate bond returns are multiples of the RBA cash rate of 1.5% with returns from many investment grade bonds delivering over 4%. This is high in an historic context.
- There are different types of bonds for different economic conditions. Floating rate bonds are preferable if you think interest rates will rise.
Fixed rate bonds are very protective in a declining interest rate environment but if you think interest rates are going up, you would prefer to invest in floating rate notes. Interest income on these bonds is tied to an underlying benchmark, the bank bill swap rate (BBSW) which is observed each business day. The interest on the bonds is adjusted according to BBSW on a quarterly basis.
If interest rates start going up, so does your income. The prices of floating rate notes tend to be much more stable than fixed rate bonds, providing more constancy and much less interest rate risk.
- If you are worried about rising interest rates limit your investment in long dated fixed and long duration bonds.
Long dated fixed rate bonds are going to be most impacted in a rising interest rate environment. One of the ways we measure risk of bonds is known as duration*.
The longer the duration of a bond, the greater the potential impact of rising interest rates. For example, long term US treasury bond holders lost 8.11% over the Eisenhower recession years of 1955 to 1959, while intermediate term bond holders had minor losses in four of the five years but saw an overall positive return of 4.81%.
Source: Ibbotson - Long term refers to 20 years, while intermediate five years.
*Duration – Is a useful measure of risk in bond investment represented in years. Developed in 1938 by Fredric Macaulay, duration measures the number of years needed to recover the cost of the bond, taking into account the present value of all coupon payments and the principal payment received in the future. Bonds with higher duration typically carry more risk and thus have higher price volatility. For vanilla fixed rate bonds, duration is always less than time to maturity, for floating rate notes, duration is typically very short and based on the next coupon reset date.
*Modified duration – Modified duration is a measure of the price sensitivity of a bond to interest rate movements. Typically, modified duration provides an estimate of how a bond will change in price for a 100 basis point (bps) or a 1% movement in interest rates. For example, say interest rates change by 1% then a $100,000 par value bond with a six year modified duration could expect a corresponding 6% change in its price, that is 1% x 6 years = 6% change.
If the traded yield on that security moved up by 1% the next trading day, then the market value of that bond would fall roughly 6% from $100,000 to $94,000. Alternatively, if the traded yield on that security declined by 1% the next trading day, then the market value of the bond would rise by 6% to $106,000.
- What happened to the bond market in 1994?
During 1994 the US Fed raised interest rates from 3% to 4.25%, which was exacerbated in longer term US treasuries, where investors had extended the term to maturity of bonds in their portfolios to increase returns. Longer term rates spiked, creating significant losses for those who had taken a different view.
Limiting longer dated bonds would help protect your portfolio from rising interest rates. However, given the state of the market and the enormity of quantitative easing, I would still be holding some longer dated fixed rate bonds to counter a Japanese style, low rate, low inflation environment.
Note: There are around USD13 trillion worth of US Treasuries on the market, most of which are fixed rate bonds. Fixed rate bond prices have an inverse relationship with yield. So that if yields move lower, influenced by lower interest rates, then fixed rate bond prices rise while the opposite is also true. Higher interest rates will mean lower bond prices. The market has speculated that the Fed would hike interest rates four times this year, but it has yet to act.