“You must be the change you wish to see in the world”
The key themes this week, not only domestically but globally, are COVID and interest rates, and one very much relies on the other. Despite mixed messages of late from central banks we believe interest rates will remain lowfor at least the next 2 years which is again shining the spotlight on higher yielding fixed income.
It looks like the RBA’s bond buying program will extend to June 2022 and entail additional purchases of $102 billion (80% AGS/20% semi government) including the $40 billion the Governor announced following the July Board meeting. This means that, in total, the RBA will have purchased around $300 billion of bonds under the program which is small relative to the Fed which has been buying around A$140b a month of late.
Recent comments by the RBA have raised the possibility for the first rate-hike to come in 2023 rather than 2024 although there is so much water to flow under the bridge that we should not be surprised if these forecasts keep changing. As an additional comment, the RBA Governor Lowe made a comment in a recent speech that the bar to raise rates was high and that several factors had to come to the party including inflation and wages growth.
The situation in the US is not that dissimilar to the one in Australia. In the minutes of the June FOMC meeting there was unmistakable evidence of growing confidence in the immediate outlook for growth and the labour market. That perceived strength has also clearly fostered a belief that underlying inflation will strengthen sustainably to target, justifying lift-off for rates, albeit not until 2023 on the Committee’s median expectation.
The chart below of the US 10 Year Govt Bond Yield, and the recent rally to 1.344%, signifies that the yields may finally be turning the corner and the yield curve will steepen again. Westpac expects FOMC rate hikes to come earlier, beginning in December 2022. However, unlike prior cycles, they believe this cycle will end with the fed funds rate more-or-less at its neutral level, which they hold to be 1.625%.
Funnily enough this week we are going to look at what role bonds play in a portfolio. Investors include bonds in their investment portfolios for a range of reasons including income generation, capital preservation, capital appreciation and as a hedge against economic slowdown. Bonds are considered a defensive asset class because they are less volatile than other asset classes such as shares. Many investors include bonds in their portfolio as a source of diversification to help reduce volatility and overall portfolio risk.
Bonds provide investors with a source of income in the form of coupon payments, which are typically paid quarterly, twice yearly or annually. The investor can use the income generated by their investments for spending or reinvestment. Shares also provide income in the form of dividends : however, such payments are less certain and tend to be less than bond coupons.
Unlike shares, the principal value of a bond is returned to the investor in full at maturity. This can make bonds attractive to security-minded investors who are concerned about losing their capital.
Although bonds are often viewed as a capital preservation tool, they also offer opportunities for capital appreciation. This occurs when investors take advantage of rising bond prices by selling their holdings prior to maturity on the secondary market. This is often referred to as investing for total return and is one of the more popular bond investment strategies.
The chart below shows the volatility of different asset classes – including bonds and shares – over different time periods. The bars above the horizon (zero line) show gains, while bars below the horizon reflect losses. You can see from the chart that bonds have a different return profile to shares, offering greater stability of returns.