One of the most surprising developments this year has been the significant sell-off in the fixed income markets. This is also commonly known as the bond market. Bonds comprise of about 50% of a balanced portfolio as equities and bonds complement each other. Bonds have been very stable in growth over the past 20+ years. This is why the sell-off in this part of the portfolio has been a shock to many as bonds have an expectation of safety and low risk.
We will outline what bonds are, why they have sold off and what expectations to have for them going forward.
What is a bond?
Think of bonds as a loan. Just like a bank loans people money to buy a house, you are loaning money to most often, governments or corporations. For this explanation, we will talk about government bonds.
Say, you have bought $10,000 in Australian government bonds in your portfolio. What you have ultimately done is you have loaned $10,000 dollars to the Australian government. The government will promise to pay you a certain amount of interest per year (just as you pay interest on a mortgage to a bank) for loaning them this money, and they will also promise to pay back your $10,000 at the end of the bond’s life. The life of a bond could range from 3 months to more than 30 years.
A bond portfolio manager simply has a portfolio of different bonds that vary in length and government/corporation they have loaned to. Within corporate bonds, you are simply loaning money to a business.
Why can I lose money if its “fixed”?
A tricky part to understand is that bonds have prices, and these prices fluctuate as interest rates go up and down. This means that the value of your bond portfolio will also fluctuate as interest rates move up and down. When interest rates go upwards, bond values will decrease and when interest rates go downwards, bond values will increase.
Interest rates have trended downwards over the last 20+ years and that is why bond managers within your portfolios have been able to generate high returns during this period. This year, as inflation has been a big concern around the world, central banks have had to raise interest rates at a near historic pace to fight this inflation. As we stated earlier, when interest rates rise, bond values fall, so when rates are increased dramatically bonds will lose money.
Why do I need bonds if I’m losing money?
Bonds have a very important relationship to equities. Historically, bonds will increase in value when equities are decreasing in value as bonds act as ‘protection’ against equity drawdowns and recessions. This is the case since bonds and equities exhibit different types of risk that drive their returns. This is an extremely important relationship that helps reduce volatility within a portfolio throughout an entire business cycle. Just like when equities fall, the prices become more attractive to buy. This concept is exactly the same with bonds and this is what we are currently seeing.
Going forward, now what?
The financial world deeply underestimated how high inflation would go and therefore underestimated how sharply central banks would raise interest rates. We do not think that interest rates can remain so elevated for extended periods of time. Having interest rates this high for long periods of time will cause economies to slowdown. When economies slowdown, interest rates will also fall. The one unknown factor is, will inflation also fall? Interest rates can only really come down once there is a sign that inflation is also coming down as high interest rates is the central bank’s main tool for fighting inflation. An economic slowdown caused by high interest rates is likely to decrease inflation over time.
Once this occurs (impossible to know exactly when), bonds are likely to start generating returns once again. During this time of higher interest rates, bonds will be yielding more (paying out those interest payments which they call coupons). Remember to focus on the time frame in which you are invested for, this is a very volatile and uncertain environment and remaining invested for the longer term should generate positive bond returns once again.
Term deposits are currently providing quite enticing interest rates and could be a method used to decrease risk within an overall portfolio if the current volatility is generating some discomfort for certain investors.
Disclaimer
The information provided in this communication has been issued by Centrepoint Alliance Ltd and Ventura Investment Management Limited (AFSL 253045).