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Cheap bonds, spiking yields Copy

Cheap bonds, spiking yields create opportunities to join the IAM 6% Club

This article was originally published on Stockhead on 17 June 2022 and is reproduced here with their permission.

Income Asset Management (ASX: IAM) is a fixed income specialist and funds management incubator, which specialises in showing fixed income investors that bonds, cash, debt capital markets, treasury management, and asset management solutions can offer better returns than a boomerang. The goal of the IAM 6% Club endeavour is to showcase how to achieve a fixed income of 6%, just like it says on the tin.

  • Bonds priced cheaply as yields spike on back of interest rate hikes
  • Unchartered territory with sell-off in both bonds and equities creating opportunities
  • Floating rate bonds have held up well amidst all the volatility in the market

Doom and gloom have been dominating financial news this week as equity markets enter correction territory. Locally, AUD82 billion was wiped from the ASX on Tuesday in its worst session since March 2020. Sell-offs extended into Wednesday before marginally opening in the green on Thursday but finishing in the red before more sharp falls on Friday.

Growing inflation, hawkish central banks, slowing economic growth, and supply shortages exacerbated by the war in Ukraine are adding to create a perfect storm. We’re not going to kick equity markets while they’re down, but Income Asset Management (ASX: IAM) Director of Credit Strategy Matthew Macreadie said for fixed income investors wanting to join the IAM 6% Club, bonds could be a good option.

Rising interest rates push bond yields up

Macreadie said bonds are priced cheaply right now with yields spiking on the back of rate hikes. The US Federal Reserve has just announced a 75-basis point increase in interest rates – the largest hike since 1994, while locally the RBA used its June meeting to announce a 50 basis point hike. Further rate rises are on the cards as central banks move to put the inflation genie back in the bottle. The Australian 10-year-government bond yield − used as a measuring benchmark − has now soared to an eight year high of 4.2%.

“The great news for fixed income investors is that further rate rises have been largely priced according to the forward rate curve in Australia,” Macreadie said. “Bond markets are forward-looking so have moved early ahead of central banks action, which means fixed income is attractive right now as an asset class.”

No place to hide

Macreadie said unusually at the same time as there’s been a broad sell-off in equity markets there has also been a broad sell-off in the bond market, which has consequently pushed yields higher. In theory there’s an inverse relationship between bonds and share markets.

“When there are prolonged price declines in equities, bond prices generally rise as investors seek a safe haven, but we haven’t seen that this time,” he said. “Part of the reason has been due to rampant inflation globally which has spooked bond and equity markets alike. Investors are trying to determine what normalised interest rates should look like depending on what happens to real economic growth and inflation down the track.”

But while 2022 has seen a broad bond sell-off, Macreadie has an optimistic outlook and believes fixed income should remain an integral part of investors’ portfolios.

“On the outlook, investment-grade bonds should perform well relative to other asset classes in a recessionary environment, all else equal,” he said. “Furthermore, central banks further rate rises have been largely priced in and yields have risen enough to make them very attractive − which should support demand for fixed income.”

Inflation-linked bonds

Inflation-linked bonds (ILBs) are designed to help mitigate the impact of inflation. While not as popular in Australia as in the US and UK, Macreadie expects to see this change with inflation tipped to hit 7% by the end of 2022.

“The appeal of ILBs − which are designed to protect investors from inflation and offer attractive returns − has grown,” he said. “Australia is only just starting out on its inflation journey, having somewhat lagged what’s happening in the US. For example, the Sydney Airport 2030 capital-indexed bond (CIB) is offering investors close to 3% in real yield terms.”

Where to make a bet

Macreadie said floating rate bonds have held up well amidst all the market volatility. The AusBond floating rate index outperformed all other local indices in the current rising rate environment over May 2022. He expects floating rate bonds to continue to do well in the short-term.

“A significant number of floating rate bonds are coming up for their reference rate or 3m BBSW reset, which is correlated to the RBA cash rate,” he said. “For comparison, the last 3m BBSW reset was 0.2% in March 2022 and forwards are pricing in around 3.2% rate for 3m BBSW by September 2022 − which means income and running yield will be considerably higher going forward.”

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