Tuesday 06 December 2016 by FIIG Securities dogotters Opinion

Bond critics overlook the critical distinctions

As published in The Australian on 6 December 2016

A common error among financial commentators is to lump all bonds into the same basket, for example "bond rout set to continue", referring to the US and Australian 10 year government bonds. But government bonds do not behave in the same way as corporate bonds – for most corporate bond investors losses, if any, will be minor

My job is to comment on financial markets and my particular expertise is fixed income. Other people have expertise in shares, or property or pork belly futures. As an expert in fixed income it has been particularly galling in recent weeks to see the explosion in commentary about the bond market from people who know as much about it as I know about pork bellies.

A common error among financial commentators is to lump all bonds into the same basket, for example "bond rout set to continue" or "it’s not a good time to invest in bonds earning 2.7 percent".

Like property, there are various bond sectors that react differently to changing economic conditions.

Government bonds do not behave in the same way as corporate bonds. The "bond rout" headline referred to US and Australian 10 year government bonds – bonds that not many individuals own directly.

Most government bonds are fixed rate bonds. When they are issued the interest paid on them is fixed, so when interest rate expectations are going down, the price rises. Over the last decade this trade has delivered some fantastic returns for investors. Now that interest rates are expected to rise, the price of the bonds has come down, generating some eye watering losses. Those that have generated the biggest losses are those issued in the last year or two that have very long terms to maturity of 30 years or more.

But corporate bonds have different metrics. To start, they pay higher interest than government bonds because they are higher risk. Returns range from 3.5 percent per annum up to 10 percent per annum.

Most corporate bonds are issued for terms of seven years or less, and as they get closer to maturity, changes in the price of the bonds due to interest rate expectations declines. There are plenty of corporate bonds in the market that have barely registered the changing government 10 year yields.

To illustrate the changes in prices, we compared the performance since late August of a long dated Australian government bond, maturing in 2033 to three corporate bonds. 

Corporate vs Australian government bonds
Source: FIIG Securities

The Australian government bond with 17 years until maturity was priced at $126 pre Trump and has since declined by $6.47. In comparison, the Downer fixed rate November 2018 bond with three years to maturity has declined by just 24 cents.  Even extending the term to maturity with the Qantas 2021 fixed rate bond, its price declined by 90 cents to $114.50, not something most investors would worry about. The price of the G8 Education floating rate bond maturing in March 2018 is flat.

In corporate bonds you get paid a credit risk premium for taking the risk the company will not pay you back.  In government bonds there is no credit risk, you are purely taking interest rate risk. The longer the term to maturity of the government or corporate bond, the higher the risk to capital given a change in interest rates.

Another significant and often overlooked fact is that there are different types of bonds. Interest on corporate bonds can be floating rate, meaning interest income changes as interest rate expectations change. Floating rate bonds are like owning rolling three month term deposits, except you don’t have to shop around for the best rate, the return is automatically adjusted for you!

One floating rate opportunity I like is Suncorp subsidiary AAI, with an expected maturity of October 2022 yielding close to 5 percent per annum. The certainty of the quarterly income and the fact capital is returned at maturity make these bonds really attractive to retirees. Note to the commentator who said bonds couldn’t compete for yield seeking investors!

Few individual investors would choose to own government bonds with such low interest rates. Investment is mainly by the largest global investors who have mandates forcing them to hold government bonds. Examples include banks, insurance companies and superannuation funds.

Managed funds will hold government bonds for liquidity and exchange traded funds will also hold them as investments must replicate an index. Unfortunately for bond ETFs, as governments issue more and more debt, they take up more and more of the various indices, unwittingly increasing exposure to government bonds for individual investors unaware of the growing allocation.

Managed bond funds and particularly bond ETFs are likely to post losses based on changes in government yields, but for most corporate bond investors, who do not hold government bonds, losses, if any, will be minor. To put it into perspective, the Bloomberg Barclays Global Aggregate Bond Index has fallen by 4.4% since Trump won office. That’s the sort of decline other asset classes can only dream about.