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Tuesday 23 April 2024 by Philip Brown Opinion

Portfolio Construction: The interaction of yield, slope, and return

When trying to construct bond portfolios, paying attention to what happens when nothing material appears to be happening is crucial. Bonds earn interest over time, so maximising the interest is important, but the shape of the yield curve dictates how individual bonds react when nothing is overtly happening. This is a concept called “bond carry” – the return you get for owning (carrying) a bond.

As we sit here in early 2024, the coming turn in the RBA cycle will be pivotal. But if the RBA doesn’t begin cutting rates until 2025, then investors may well spend all of 2024 and part of 2025 waiting for the RBA to move rates and for the yield curve to change shape. Lennon famously sang “Life is what happens to you while you’re busy making other plans”. The same thing can happen in bond markets. You need to have a long-duration position when the rally starts, but you also want to think about what happens while we wait for that rally.

FIIG advocated taking duration in anticipation of the eventual rally in our original LOCK strategy. We have recently examined precisely where to hold that duration in a piece entitled Lucky 7 which also had a follow-up podcast discussion. The long and short of it is that from here, in most foreseeable futures, the 7Y part of the bond curve performs very well. Though it’s not luck at all that makes it so; it’s driven by the shape of the yield curve and an analysis of bond carry.

The Lucky 7 piece steps through four different possible outcomes for the RBA. The scenarios range from an unexpectedly high interest rate outcome to a rate cut cycle that would only occur if the economy materially weakened. In between are two much more likely scenarios that involve much less movement in the RBA rate. Specifically, the scenarios are:

  • Scenario 1: RBA raises 25bp – the RBA hasn’t ruled out raising rates and with unemployment down and some CPI series suggesting stickiness, it wouldn’t take too much strong data to induce a further rate rise. That being said, most data series are showing slow trend weakness, so strong data has been relatively rare of late.


  • Scenario 2: RBA does nothing – the inflation pulse is working through the economy while moderately high rates are constraining growth and lowering CPI without causing unduly fast rises in the unemployment rate. If it ain’t broke, don’t fix it. The RBA simply leaves rates unchanged for 12 months.


  • Scenario 3: RBA meets the current market pricing for 2024 (circa 50bp of cuts) – the market has priced a moderate rate cut cycle that lowers rates back towards the neutral level over the coming year. In this scenario, the RBA lowers rates by around 50bp on the schedule priced into bond markets.


  • Scenario 4: RBA is forced to cut rates aggressively because the economy weakens – while things look to be holding together now, there are also some signs of trend weakness in the economy. If the weakness comes to the fore and becomes more pronounced, the RBA might be forced to lower rates aggressively into stimulatory territory.

The below chart shows the 12-month return to each Government bond if the RBA proceeds as outlined in the respective scenarios. The 7Y sector performs tolerably well compared to the other sectors in the two extreme scenarios (1 and 4). So even in a tail-end risk scenario, the 7Y sector is fine to own. The way to read this chart is to compare the returns for each individual scenario on a standalone basis. The chart represents the returns to bonds in a particular state of the world.  What we are looking for is a sector of the curve that does well compared to the other points on its line but does so on all four lines. You cannot use this chart to compare between the scenarios.

Bond returns in different RBA scenarios – 7Y doing well

Source: FIIG Securities, Bloomberg

However, it’s the quiet middle scenarios where the 7Y sector shines. The 7Y is the strongest sector in the two more likely scenarios (2 and 3). The unexpected scenarios with large movements above make the nuance of the more likely scenarios hard to see. As such, the below chart shows the bond returns in only the two more likely scenarios. As you can see the 7Y sector (bonds which are currently around 2031 or 2032) performs materially better than surrounding bonds.

Bond returns in different RBA scenarios – Scenarios 2 and 3

Source: FIIG Securities, Bloomberg

As we noted above, there are good reasons why the 7Y sector performs so well. The main one being the slope of the curve.

Generally, bond investors don’t want to lock their money away for the long term, but bond borrowers do want to be able to secure funding for longer periods. The compromise is that borrowers pay higher yields for longer-term investments. That’s why the yield curve is normally positively sloped. Unless the RBA cash rate is likely to fall in the near future, the longer the bond the higher the yield.

But the benefit from the higher yields on longer bonds doesn’t always accrue consistently across time. The coupon will be higher once the coupon is fixed, but the bond price can shift, too.

Because bonds have a fixed maturity date, each day that passes means they are one day shorter. In a year’s time, a bond that is currently a three-year bond is only a two-year bond, etc. etc. If nothing material happens in that year, then we actually have a decent estimate of what the one year ahead price for a 3Y bond is: it’s the current price of the 2Y bond. But because bonds are mostly considered in yield terms and the bond price is higher the lower the yield, the greatest returns for a bond are in places where the yield curve is locally steep.

You can also think about this from the other direction. If a 4Y bond has the same yield as a 3Y bond, investors are not being rewarded for extending their investment. But if the same curve has a steep slope between 4Y and 5Y then the extra inducement to extend to 5Y is material. That’s what we are looking for: places where the yield curve is steep in the vicinity of the proposed investment.

On the current curve, the steepest part is the 5Y to 7Y sector. Investors receive materially higher yields for investing for 7Y rather than 5Y. This outperformance is a strong reason why the 7Y part of the curve performs well in the “quiet” RBA scenarios we modelled above.

The current shape of the Government bond curve

Source: FIIG Securities, Bloomberg

At different points in the cycle the analysis conducted here will show different parts of the curve to be most beneficial.

As things currently stand, however, the 7Y part of the curve offers duration in an eventual rally and offers higher yields in the short-term. Finally, the 7Y sector offers the prospect of outperformance over the medium-term because 5Y and 6Y bonds have materially higher prices. If nothing too unexpected happens, the relatively cheap 7Y bond purchased today will be a more expensive 5Y bond in a couple of years’ time.

FIIG has dubbed the 7Y sector the “Lucky 7” because it is likely to perform well in most scenarios. The driver of that return is the steep part of the curve between the 5Y and the 7Y, which is causing strong bond carry (that is, high anticipated returns) for the 7Y bonds.