Duration and How Investors Should be Positioning
In Australia and many other major markets, longer-dated yields have fallen consistently over the last 20+ years, providing excellent returns and performance. Longer-dated yields plummeted to record lows in 2020 following the COVID-19 shock. Similarly, many investors will remember the significant volatility in longer-dated yields in 2008 and 2009, when central bank policymakers and global bond markets responded to the GFC.
Higher longer-dated yields will impact equity markets that are being priced on the basis of yields remaining lower for longer. Market theory suggests interest rates and, in turn, longer-dated yields, will start to increase over time as economic activity picks up and inflationary forces gather momentum.
In our view, an increase in longer-dated yields seems likely over time as accommodative policy settings start to be wound back and official interest rates start to rise. For example, longer-dated New Zealand yields increased as the RBNZ started to communicate the potential for interest rate rises in late 2021. This corresponded with a return of around -7% from the S&P/NZX NZ Government Bond Total Return Index for the 12 months ending September 2021.
However, we’re not suggesting longer-dated yields are going to rise meaningfully in the immediate future — but they are likely to increase over time as economic conditions improve. With that in mind, it’s important that investors are aware of ways they can mitigate the impact of higher longer-dated yields.
Chart 1. Australian 10 Year Bonds Versus US 10 Year Bonds
What can be done to mitigate the impact of higher longer-dated yields?
- Consider an allocation to floating-rate credit? (Which has no interest rate sensitivity)
- Consider an allocation to shorter-dated fixed rate bonds? (Which has less interest rate sensitivity than longer-dated fixed rate bonds)
- Consider an allocation to higher yield? (Which generally has less interest rate sensitivity than investment grade bonds.) Some examples include Emeco 6.25% 2026s, Jervois Mining 12.5% 2026s, and Coburn Resources 12% 2026s — which all have less than five years to run.
Be mindful, it is still critical for investors to have a well-diversified fixed income portfolio to protect themselves against a fall in risk assets. A well-diversified portfolio should have an allocation to floating rate bonds, inflation-linked bonds, high-yielding bonds, and shorter-duration fixed-rate bonds. Furthermore, the experience of early 2020 also showed us that it was useful to have some ammunition left in the tank.
Again, there may also be some investors who view the recent volatility in longer-dated yields as an opportunity to buy investment grade longer-dated fixed rate bonds at improved levels. These bonds should be part of portfolio holdings and will provide a steady coupon stream — so if they can be purchased at a lower mark to market (MTM) price — even better.
While MTM valuations may move up and down with longer-dated yields, these bonds have less volatility than shares, and default rates in the investment grade space are extremely low, providing certainty over capital return.
While longer-dated yields are free to move, shorter-dated yields have previously been anchored by RBA policy measures, such as yield curve control (YCC). Alongside cutting the official benchmark cash rate to 0.1%, the RBA has also targeted a yield of 0.1% on the three-year bond yield.
In today’s Monetary Policy Decision, the board left the official cash rate at 0.1% and announced it would maintain its policy of buying AUD4bn in government bonds a week until mid-February 2022. However, the board also announced it would discontinue targeting a yield of 0.1% on the three-year bond yield.
The RBA’s decision to abandon the YCC was due to both Australia’s economic improvement and progress towards the 2 to 3% inflation target. In previous meetings, RBA Governor Philip Lowe has consistently said the official cash rate would be unlikely to lift before 2024. However, this was not reiterated at today’s meeting.
What does this mean for shorter-dated yields?
The 3M Bank Bill Swap Rate (BBSW) is correlated with the official cash rate and used to reset the coupon each quarter on floating-rate credit. It is a forward-looking metric and gives investors an indication of interest rate moves. With prior statements indicating the official cash rate would be unlikely to change before 2024, 3M BBSW has remained anchored at low levels.
However, markets are now expecting the 3M BBSW to move around 1% in late 2023 (two years), versus the previous expectations of late 2025 (four years). For late 2025, the expectation has moved to 3M BBSW+1.5% as shown in the chart below.
While this move is still from historic lows, it reiterates the opportunity to add floating-rate credit. If 3M BBSW continues to adjust higher, floating-rate credit will benefit from an increase in the coupon as it is reset each quarter.
Chart 2. AUD 3M BBSW Swap Rate Expectations
Chart 3. Australian 10 Year Bonds Versus Australian 3 Year Bonds
About Matthew Macreadie
Matthew’s current responsibilities include providing credit commentary/views on the bond market and specific issuers, with the aim of aiding investors to make better risk-return decisions.
Prior to joining Income Asset Management, Matthew spent eight years working as a Credit Portfolio Manager at Aberdeen Standard, where he was responsible for the credit portfolio construction and security selection across a wide range of financial and non-financial sectors.
Matthew began his career at KPMG working in Auditing and Assurance within the consumer and industrials group. Matthew holds a Masters of Applied Finance from Macquarie University and a Bachelor of Commerce from UNSW.