Since the outcome of the US Presidential election there has been plenty of talk around the rapid increase in yields on longer dated government bonds. Most government bonds are fixed rate bonds and when yields rise, the price falls. But that rule does not apply to all bonds – a sure way to spot a market commentator that does not understand the bond market
Why have bond yields risen?
There are a number of factors driving this move – but the reality of President elect Trump’s plans to introduce substantial tax cuts, ramp up infrastructure spending, wind back regulations and an expansive energy policy has raised the prospect of higher inflation.
This has resulted in a good deal of sensationalist press coverage. Many so called ‘experts’ fail to understand the bond market and unwittingly put all bonds in the same basket.
When you read a negative bond article use this checklist to determine the author’s credibility:
- Is there any distinction between government and corporate bonds?
- Is there a broad and untrue comment that “as yields rise, bond prices fall”?
- Do they mention three types of bonds: fixed, floating and inflation linked?
The reality is that many corporate bonds have barely been impacted. Government bonds have almost zero credit risk, and as such are priced purely on the future value of the bond at the time of maturity. Further, government bonds tend to have longer dated maturities with lower coupons (interest rates), which increase the duration* risk. In other words, a change in the yield of a longer dated government bond has a much bigger impact on its price than a shorter dated higher yielding corporate bond.
*See definition at the end of the note
Figure 1 Source: FIIG Securities Note: Bond price excludes accrued interest
Figure 1 shows movements for a longer dated 2033 maturity Australian government bond. You can see that the price has fluctuated a lot over the last two years, from a low of $106.09 in September 2014 to a high of $135.34 in August 2016.
This is especially noticeable in the last few months, reflected in the sharp decline in price due to rising yields post the US election. But this evidence of duration risk does not ring true for all bonds – corporate bonds tend to have shorter maturities and higher coupons. This diminishes the duration risk, as a rise in yield will have a smaller impact on the price.
Figure 2 shows price movements for three corporate bonds – all maturing within the next five years – versus the longer dated 2033 Australian government bond.
Figure 2
Source: FIIG Securities
Note: Bond prices exclude accrued interest
It’s important to note corporate bonds are subjected to credit risk or the risk of default by the borrowing entity. This is a key driver in the market determining the price of a corporate bond. As such, the factors that are driving government bond prices lower, in some ways, can point to an improving credit environment for the same reasons we have seen the equity market undergo a recent rally. A pickup in economic activity from tax cuts and infrastructure spending will see the underlying credit worthiness of some corporate bonds improve – this is reflected in their price.
High yield bond prices are most affected by changes in the capacity to repay the bond compared to small changes in interest rates, shown in the relative stability of the Sunland and G8 Education bonds. The investment grade, fixed rate Qantas bond has shown some movement as you would expect, with the price before the US election of $115.236 declining to $114.050 as of 29 November 2016.
High yield corporate bonds have additional protection to help mitigate the risk of default. These are known as covenants and examples include:
- Cross defaults
- Limitations on debt (both secured and total)
- Restricted dividends / share buybacks
- Restrictions on asset sales and application or proceeds
- Covenants around interest coverage, and net debt to earning before interest, tax, depreciation and amortisation
Do you need to take any action?
If you are worried about rising interest rates in the US, you may want to rethink your asset allocation. Two important factors to check:
- Your allocation to fixed rate bonds and their term to maturity. Consider reweighting to floating rate and shorter dated fixed rate bonds.
- The duration of your overall portfolio. Long duration means greater sensitivity to changes in interest rates. Consider shortening portfolio duration. In most cases corporate bond portfolios will typically have shorter duration of less than five years.
Glossary
Bond Covenants
A bond covenant is a legally binding term of agreement between a bond issuer and a bond holder. Bond covenants are designed to protect the interests of both parties and are enforceable throughout the entire life of the bond until maturity.
Credit risk
The risk that an issuer may be unable to meet the interest or capital repayments on the loan when they fall due. Generally, the higher the credit risk of the issuer, the higher the interest rate that investors will expect in order to risk lending funds to the issuer. Ratings agencies like Standard & Poor’s and Moody’s provide an independent credit rating service that allows investors to assess and grade issuers.
Duration
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.
Yield
The yield is the expected return on an investment. For more information on the different types of yield, please visit this article.