With Central Banks raising interest rates after years of ultra-loose monetary policies, some investors have shied away from adding longer dated fixed coupon bonds, which are more sensitive to interest rate movements. However, with yields higher, the attractive returns on offer makes them a compelling inclusion in portfolios. Here we discuss why now is the time to be considering longer dated fixed coupon bonds.
Background
After decades of falling interest rates and yields, we have experienced a dramatic reversal over the past year, driven by inflation. For much of the last decade inflation (as measured by Consumer Price Index CPI year on year) has been below the Reserve Bank of Australia’s (RBA) 2% - 3% target band, as illustrated in the chart below. However, after bottoming out at -0.3% in June 2020 at the onset of COVID-19, inflation has surged to 6.1% and it is expected to rise further this year before easing in 2023 and 2024.
The jump in inflation has pushed yields higher and forced the RBA’s hand in rising interest rates. As recently as late last year the rhetoric from the Central Bank pointed to no interest rate increases until at least 2024. However, as this position became increasingly untenable to hold, the RBA had to completely change tack. As a result, they were much later to the interest rate rising party among the Central Banks. Australia trailed New Zealand by eight months, the UK by four months and the US by two months, as shown in the chart below.
This jump in inflation, yields and interest rates has had the most notable impact on longer dated fixed rate bonds. It stands to reason that if you lock in a long-term income stream of 2% - 3% and inflation moves >5%, that income stream quickly looks less attractive. This has resulted in a sharp downward adjustment in the capital value of many longer dated fixed rate bonds.
So where does that leave these bonds now?
When considering whether to buy/sell or hold a bond I almost always focus on the yield to call/maturity. The yield to maturity on many of these longer dated fixed rate bonds looks very attractive given the current capital values. I have recently given presentations where I have removed the capital values and just presented the yields, as I have done in the table below.
I would be comfortable holding any of these in a portfolio based on the yields to maturity. For investors who are currently underweight longer dated bonds I think that this is an opportunistic time to add. I am not necessarily saying to move heavily overweight in this area but having 10% - 20% of a portfolio in investment grade bonds that will provide yields to maturity of 5.77% - 6.72% over the next 7 – 9 years looks very attractive to me. Perhaps slightly less so for pure income seeking investors, as a material amount of the returns will come by way of capital gain instead of income. This is reflected in the running yields which are lower.
These bonds will continue to experience capital volatility however the main risk here is that the RBA is unable to tame inflation. There is little argument that the RBA was late to start increasing interest rates, but they have tried to catch up with the equivalent of ten 0.25% increases across the last six meetings. They are clearly now taking inflation seriously and to quote the former head of European Central Bank (ECB) Mario Draghi during the European debt crisis, they seem to be in a mood to do “whatever it takes” to win the battle against inflation.
I often find when talking to people about bonds they are fixated on ‘only adding fixed’ or ‘only adding floating’. There are people who are no doubt cautious about longer dated fixed rate bonds however, I think that the time to be cautious was a year or two ago. Now looks more like an opportunity. We are also looking to build diversified portfolios and that includes all, or most, of the following – fixed, floating, inflation linked, short, long, investment grade and high yield and in many cases also foreign currency bonds.
I have spent much of my bond career being very wary of taking duration risk, due to the potential for capital volatility, however now I think it is an area worthy serious consideration.