RATES go up, bonds go down. It’s an investing truism that has become ingrained in our thinking.
But what if, in fact, bonds had the potential to provide an investment return during central interest rate hiking cycles?
That’s the finding from research by Oliver Ge, a portfolio manager with Pendal’s Income and Fixed Interest team.
Monetary policy tightening cycles are actually kinder on bonds than people believe, Ge says.
“The key is that it depends on how much is priced into the bond market at the point central banks start lifting rates.
“Looking at history, an investor who buys bonds at the moment of the first rate hike in a cycle and sells at the last rate hike actually gets quite a substantial return.”
The finding demonstrates that there is a lot more nuance to the classic doctrine of “rates go up, bonds go down”, says Ge.
Since the 1990s there have four rate hiking cycles in Australia, each averaging an increase of 2.25 per cent to the RBA’s policy rate, he says. The annualised bond return over the same period was more than 4 per cent.
“The compelling story is don’t ignore bonds when rates are rising — they can still give you mid-single digit returns.
“That’s quite significant in a market where equities are negative.”
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The explanation for why bonds had positive returns over those times is based on two factors, he says.
First, rate hikes do not materialise unannounced. The RBA broadcasts its decisions in advance and a considerable portion of future hikes are already in the price of the bonds before the first hike.
This means a 25 basis points move higher rarely translates into a direct one-for-one change in the yield of a bond, says Ge.
“During the 2009-2010 cycle, the RBA moved the policy rate up by 175 basis point from 3 per cent to 4.75 per cent. Over the same horizon, a five-year Commonwealth government bond moved up by around only 35 basis points,” he says.
The second thing is the pace of rate hikes. In principle, the more gradual a central bank tightens, the more income a bond can accrue to offset would-be losses, says Ge.
By magnitude, the largest tightening cycle over the last 30 years was 300 basis points, but it occurred over a six-year window, allowing bonds to maintain mid-single digit returns per annum despite the absolute quantum of moves.
“Right now, the market expects the RBA to kick off their hiking cycle in June, ending in mid-2024 at a peak rate north of 3 per cent.
“This puts the expected bond experience somewhere between the last two hiking cycles, both of which resulted in a positive outcome for fixed income investors.
“While a negative shock can’t be ruled out, the likelihood of further inflation surprise is diminishing.
“There’s already a lot priced into bonds. And it’s reasonable to say that we’re closer to the end of this higher rates move than we are at the start.”
Oliver Ge is an Assistant Portfolio Manager with Pendal’s Income and Fixed Interest (IFI) team.
Oliver works on developing and running key quantitative investment models, and acting as trading support for the Income & Fixed Interest team. Oliver received his Bachelor of Commerce (Finance) from the University of Sydney and is also a CFA Charterholder.
Pendal’s IFI boutique is one of the most experienced and well-regarded fixed income teams in Australia. In 2020 the team won the Australian Fixed Interest category in the Zenith awards.
The invests across income, composite, pure alpha, global and Australian government strategies.
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