The RBA has cut the cash rate to the lowest level in history. With more rate cuts on the way and bond prices likely to rally further, we believe it is time for investors to start adjusting their expectation to a lower yielding environment.
At the June rate decision meeting, the RBA cut the cash rate to 1.25% and has flagged that it will likely lower the cash rate by another 0.25% over the course of 2019. This should lead to a further fall in yields.
One of the key principles of investing is diversification. Investors are often advised that they should invest in both bonds and equities because the performance of these is typically negatively correlated. Meaning, when equities rally, higher rated bond yields usually go up (prices lower) and vice versa.
However, we are currently seeing unprecedented market conditions where equities continue to push higher and bond yields are moving lower (prices higher). This isn’t sustainable in the long-term, and with continued weaker economic conditions expected, it would suggest lower bond yields will persist.
Bonds and equities rallying
We continue to expect volatility to rise in 2019 as geopolitical risks and trade tensions impact economic growth. Government bond yields have been reflecting this flight to safety with yields in both Australia and US at or close to record historical lows (prices at their highs). The Australian government 10-year benchmark yield is now below 1.30%, which is about 1% lower than levels at the beginning of the year.
The chart above shows the gradual fall in yields over 2019, however, interestingly this has coincided with a markedly upward move in equities. This means that either bond yields are incorrect in their bearish view of the economy or equities are overvalued. It is unlikely that this trend of rising share market and falling yields will continue for much longer.
Without a catalyst on the horizon to justify the robust move higher in equities, we view the move lower in bond yields as a better indication of what is set to continue.
Bond yields expected to move lower
It is important for investors to diversify their invested wealth by asset type (fixed income, equities, property, and cash) to cushion against a correction in any one market.
The rule of diversification does not only apply to overall portfolios, it is also a key investment consideration within each asset class. A fixed income portfolio should be diversified by underlying investments with allocation to investment grade securities for capital preservation and high yield bonds for coupon income.
Given the backdrop of a global economic slowdown coupled with lower interest rates in most developed economies, it is not surprising to see global and domestic bond yields moving lower. The chart below shows the Bloomberg AusBond Credit Index, which measures performance of Australian corporate bonds. Given the low proportion of Australian high yield bonds in issuance, the majority of securities in this index are high grade with a composite rating of A+. Nevertheless, they do capture a component of credit risk over and above government yields.
This chart highlights the drop in yields over the last six months. Similar to longer dated government bond yields, the yield of the AusBond Credit Index has fallen more than 1.00% since the beginning of the year and a staggering 1.80% in the last 5 years. This lower yield environment is expected to last for the foreseeable future.
Conclusion
In the current environment, we believe investors should assess each bond investment not just by the capital price but by the yield offered at that price. We, in the Investment Strategy Group, regularly conduct relative value assessment to highlight any bonds that we believe offer better value than the comparable universe. We still see value across a number of high yield bonds that can supplement income in a portfolio which has a strong allocation to investment grade bonds.
Ready to find out how Corporate Bonds can help generate predictable income?
Get a free consultation