INVESTORS have struggled to earn good returns from fixed income assets in recent years.
But yields on government bonds have risen over the past year — and the negative correlation between bonds and risk assets has re-emerged.
That reflects the narrative around a recession in the United States, Europe and possibly even Australia, says Pendal’s head of income strategies Amy Xie Patrick.
“The bond story of recent years has been flipped on its head,” says Xie Patrick.
“Buying 10-year government bonds in Australia can get you nearly 4 per cent. At the height of the pandemic, it was 50 basis points.
“Now the credit risk-free rate is 4 per cent, which raises the bar for other asset classes.”
Those other assets might be riskier fixed income instruments including junk bonds and private sector debt, or other asset classes such as equities and alternatives.
When government bonds yields have risen so much, so quickly, the economics of all other investments change.
“You can get credit-risk free, 10-year yields in Australia for 10 per cent. That sounds pretty good,” Xie Patrick says.
Investors should consider buying high-quality sovereigns, such as United States or Australian bonds, which are free from credit risk, says Xie Patrick.
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Investors have been hesitant to include bonds in portfolios in recent years — but that’s changing, says Xie Patrick.
“For the last three years equity yields were much higher than bond yields. Investors were better off sitting in equities and collecting the dividend.”
But fears of a recession have changed all that. Xie Patrick points out that it isn’t central banks around the world that will trigger a recession. Rather, it’s tumbling consumer sentiment that reflects inflation.
“You’re filling up your petrol tank and the cost at the bowser just keeps going up. Grocery bills are so much higher and feeding a family is becoming expensive. None of that is good for consumer sentiment,” she says.
Private sector sentiment is critical to economic growth because confidence leads to higher spending. The most recent Westpac-Melbourne Institute of consumer confidence in Australia (PDF) – the long-time benchmark – this month fell to its lowest level since the beginning of the pandemic.
In the US, the benchmark measure from the University of Michigan has hit a record low.
Consumer sentiment isn’t going to improve quickly, Xie Patrick says.
“High levels of inflation tends to lead consumer sentiment by six to 12 months, so even if inflation has peaked, we’ve still got six to 12 months of poor consumer sentiment. That’s not great.”
This adds to the argument why bonds are back.
One lingering question for investors is whether four per cent is a good return, given inflation is currently higher than that.
“To put that value into perspective, inflation markets infer that over ten years inflation will be, on average, around two-and-a-half per cent, which is the Reserve Bank’s inflation target,” Xie Patrick says. “Ten-year bonds are yielding a nominal rate of four per cent.”
“By owning a 10-year Australian bond, you are taking effectively no credit risk, keeping up with the two-and-a-half per cent long-term rate of inflation and then getting another one-and-a-half per cent.
“You’re getting paid to own something without credit risk and keep up with inflation.
“The value proposition for bonds is really back.”
Amy is Pendal’s Head of Income Strategies. She has extensive experience and expertise in emerging markets, global high yield and investment grade credit and holds an honours degree in economics from Cambridge University.
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia. In 2021 the team won Lonsec’s Active Fixed Income Fund of the Year Award. In 2020 they won the Australian Fixed Interest category in the Zenith awards.
The team oversees A$22 billion invested across income, composite, pure alpha, global and Australian government strategies.
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