Fear is often worse than reality

Bonds have been in the news lately as we have seen growth rebound, inflation expectations rebound, and bond yields rising. What exactly has happened and what does it mean for bond investors?

If you look back at timing, the rising yields started to materialise around the fourth quarter of last year. The timing is important because that was when vaccines started to be approved by governments around the world, and in fact, the US and UK started their vaccination rollouts.

The visibility that the market/investors started to have on coming out of the pandemic was important and bolstered expectations of growth and inflation, so I think that was really the key driver and the key timing of it.

Then we look at the components, 10-year yields in Australia and the US rose by over a percent and three-quarters of that was from rising inflation expectations, and only a very small part was a rise in real yields. It was a very healthy normalisation of interest rates and you saw that it was in the context of positive returns in equity markets and risk assets.

So we would characterise this as a healthy normalisation of interest rate levels. It is always important to put it into context as well in terms of bond returns; I think rising yields always come with hand-wringing and fear from investors about what that will mean for returns on bond portfolios.

This is another really healthy case in point that often that fear is worse than the reality. If you look across our suite of core bond portfolios, they have actually all had positive 12-month returns to the end of March. So that fear is often worse than the reality, so when we put it into context I think it’s just been a very healthy rise in interest rates to more normal levels.

With an eye on the 12-month experience for bond investors, you mentioned people can become quite fixated on rising bond yields. How can a bond fund generate positive returns even as yields are rising?

It’s a good question. The first point is that bond funds aren’t just comprised of 10-year sovereigns. As we said, 10-year sovereign went up by nearly a percent in Australia and the US, but bond portfolios are comprised of bonds of varying maturities and credit profiles. So they have a lot of natural buffers in them to protect from rising rates. Three-month interest rates hardly went anywhere because central banks were anchoring them.

Corporate bonds both outperformed because growth and profit expectations improved and credit spreads came in and, of course, as interest rates are going up you are reinvesting at higher levels of interest rates. Accordingly, there are a lot of natural buffers for a bond portfolio to perform reasonably well even in rising rate environments. 

Then, there is a wealth of tools for active managers like ourselves to deploy as well to protect investors from rising rates.

One of the drivers of rising bond yields was increasing inflation expectations and there have been a variety of views on where inflation is heading, with some commentators even calling for significantly higher inflation to the point of runaway inflation. What’s your view on that and do you think those fears are well-founded?

We are definitely going to see higher inflation prints over the next couple of quarters and there are a couple of things driving that. We’ve seen higher oil and energy prices, that’s going to be a driver. But when you are looking at 12-month numbers, a lot of the deeply negative prints from CPI or inflation last year start to roll off. If you remember free childcare in Australia, we had a very big negative print in the second quarter as a result of that. So as those negatives roll off the 12-month window looks very positive. As we go through this year, we are going to see some higher year on year levels of inflation, probably towards the top of a lot of central banks' target bands, but it is going to be transitory. A lot of it is optical as negatives from last year roll-off. By the end of this year and as we go through even next year we are still going to be comfortably below central bank targets for inflation.

So for the next couple of years, apart from a transitory move higher through this year, inflation will remain below central bank targets. To see a sustained rise in inflation we need to start seeing wage pressure. And to get wage pressure you need tight labour markets.

A tight labour market in Australia - the unemployment rate somewhere in the 4’s, we are currently at a 6 - so we are a long way from seeing tight labour markets and wage pressures and certainly for the next couple of years, this year and next year, our expectation is inflation to average comfortably below central bank targets.

Is it fair to say central banks would be somewhat happy to see inflation actually get to their target ranges given that they have undershot for quite a period of time?

That’s right, and they have all adjusted their policy now. They do want to see a period of sustained inflation above their target or at the top of their target band so it is certainly something that they would be comfortable with, but not something we are expecting for the next couple of years.

As you mentioned we have seen bond yields rise by over a percent since August last year, so the final question is where to from here?  

We think we have a fairly range-bound outlook for interest rates now. As I said earlier we think that the recent move higher has been a healthy one, and we are back to more normal levels. Certainly, we are not at abnormally low levels anymore. When you look at 10-year yields in Australia and the US we were here in 2016; we are no longer at pandemic abnormal levels. As we emerge from the pandemic we are not expecting to see this sort of abrupt move higher and there to be structurally higher levels of interest rates than they were before the pandemic. So we are getting back to levels that are more normal, and we think we are at a level now where the near term outlook is fairly range-bound. There has been a very healthy rise and yield and carry on bond portfolios have come back to fairly attractive levels.

So certainly when we look forward, core bond portfolios will be able to perform that dual role of being a good store of value and provide the diversification benefits for broader risky portfolios.

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