Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 531

Bond opportunities in a higher rate world

As investors navigate a potential recession and the possibility of higher interest rates for longer, the lure of fixed income is understandable. Government bond prices typically appreciate as economies enter recession, which could help offset losses that may occur in other parts of a portfolio – namely equities (as earnings decline) and real estate (as home prices depreciate) – making bonds a key element of a balanced portfolio.

According to Reuters, Australia’s $1.5 trillion in pension assets (as part of the $3.5 trillion superannuation sector) has increased its investments in local and foreign debt “by more than $20 billion over the past year as higher yields burnished an asset class overlooked in a country where equities traditionally rule.”

AustralianSuper told Reuters it had doubled debt assets to $40 billion over the past year while Australian Retirement Trust, which manages $240 billion, lifted its fixed income allocation to 13.7% from 12.5%, according to filings.

Fixed income exchange traded products (ETPs) have continued to increase in popularity with the industry growing to $23.4 billion from $16.2 billion in 2022 in Australia. In 2023, fixed income strategies have taken the lion’s share of ETP flows.

Using fixed income to play the yield curve

One way fixed income investors can add relative value to their bond portfolio is to ‘play’ the yield curve. The yield curve is a line that plots the yields of Australian Government Bonds (AGBs) with differing maturity dates.

Chart 1: The Australian Government Bond yield curve

The slope of the yield curve reflects the difference between yields on short-term bonds and long-term bonds. The yields on short- and long-term bonds can be different because investors have expectations, which are uncertain, that the cash rate in the future might differ from the cash rate today.

For example, the yield on a 10-year bond reflects investors' expectations for the cash rate over the next 10 years, along with the uncertainty associated with this. Because longer-term yields are more difficult to predict, their yields tend to move more than shorter-term bonds.

The yield curve is an important economic indicator because it is a source of information about investors' expectations for future interest rates, economic growth, and inflation.

It is therefore possible for investors to take a view of the slope of the curve and position their portfolios for this.

Different yields curves and what they mean

There are several scenarios that cater for a bond portfolio exposure to be either overweight or underweight the short, medium or long end of the yield curve. For example, if an investor thinks interest rates will rise, they might shorten the duration of their portfolio by using a shorter-term bond such as a 1-5 year to reduce duration risk. 

On the flip side if an investor thinks interest rates have peaked, they could invest in Australian government bonds that have longer maturity dates, for example 10 years plus. The longer the duration the more bond prices increase when interest rates fall.

A ‘normal’ yield curve is upward sloping where short-term yields are lower than long-term yields. Typically, this type of yield curve is seen during periods of economic expansion. In this environment, investors demand higher yields on longer-term bonds as compensation for inflation and future rate rises.

Chart 2: Normal Yield Curve

Source: VanEck. For illustrative purposes.

So, in the event bond markets forebode economic conditions and interest rates  deteriorate, the long end of the curve typically decreases, resulting in a ‘flattening’ of the curve.

Chart 3: Normal to flat yield curve

Source: VanEck. For illustrative purposes.

A more exceptional scenario is where bond markets forecast the economy to enter a recession or slowdown, such that the yield curve inverts where short-dated yields are higher than long-dated. In the US, when this happens it is often a leading indicator of an impending recession. At the least, an inverted curve may indicate that economic growth is going to slow and that central banks will need to cut rates in the near term to stimulate economic growth.

Chart 4: Inverted yield curve

Source: VanEck. For illustrative purposes.

In both scenarios, investors with long-dated yield exposure benefit from bond price increases as yields fall. Investing in long-dated bonds is considered a defensive strategy as prices typically increase when forecast economic conditions deteriorate.

In another scenario, the yield curve can steepen at the long end, higher than it does at the short end is known as a 'bear steepen'. Bear, because rises in yields are bad, or ‘bearish’, for bonds. Typically, this type of yield curve movement is associated with an environment in which investors think interest rates and economic activity are expected to rise. Shortest duration exposure is preferred here, to minimise the negative impact of rising yields on bond prices.

Chart 5: Normal to bear steepen

Source: VanEck. For illustrative purposes.

Sometimes yields fall, but short-term yields by more than long-term yields. This may occur in a falling-rate environment where the market thinks there will be near-term rate cuts and they will be few or temporary. The jargon for this is a ‘bull steepen’ (bull – because falls in yields are good, or bullish, for bonds). Exposure to the short and middle parts of the curves is preferred to benefit more from the impact of falling yields on bond prices.

Chart 6: Normal curve to bull steepens

Source: VanEck. For illustrative purposes

 

Cameron McCormack is a Portfolio Manager at VanEck Investments Limited, a sponsor of Firstlinks. This is general information only and does not take into account any person’s financial objectives, situation or needs. Any views expressed are opinions of the author at the time of writing and is not a recommendation to act. For more insights on bonds, visit: vaneck.com.au/blog/income-investing/.

For more articles and papers from VanEck, click here.

 

RELATED ARTICLES

Why have bond fund distributions been shrinking?

Hunting for value in fixed income

Why 'Don't fight the Fed' now has a different meaning

banner

Most viewed in recent weeks

Which generation had it toughest?

Each generation believes its economic challenges were uniquely tough - but what does the data say? A closer look reveals a more nuanced, complex story behind the generational hardship debate. 

Maybe it’s time to consider taxing the family home

Australia could unlock smarter investment and greater equity by reforming housing tax concessions. Rethinking exemptions on the family home could benefit most Australians, especially renters and owners of modest homes.

The best way to get rich and retire early

This goes through the different options including shares, property and business ownership and declares a winner, as well as outlining the mindset needed to earn enough to never have to work again.

A perfect storm for housing affordability in Australia

Everyone has a theory as to why housing in Australia is so expensive. There are a lot of different factors at play, from skewed migration patterns to banking trends and housing's status as a national obsession.

Chinese steel - building a Sydney Harbour Bridge every 10 minutes

China's steel production, equivalent to building one Sydney Harbour Bridge every 10 minutes, has driven Australia's economic growth. With China's slowdown, what does this mean for Australia's economy and investments?

Supercharging the ‘4% rule’ to ensure a richer retirement

The creator of the 4% rule for retirement withdrawals, Bill Bengen, has written a new book outlining fresh strategies to outlive your money, including holding fewer stocks in early retirement before increasing allocations.

Latest Updates

Superannuation

Super crosses the retirement Rubicon

Australia's superannuation system faces a 'Rubicon' moment, a turning point where the focus is shifting from accumulation phase to retirement readiness, but unfortunately, many funds are not rising to the challenge.

Economy

Should Australia follow Trump's new brand of capitalism?

A new brand of capitalism may be emerging - one where governments take equity in private companies. Is it state overreach, or a smarter way to fund public goods without raising taxes?

Gold

Why gold may keep rising - and what could stop it

Central banks are buying, Asia’s investing, and gold’s going digital. The World Gold Council CEO reveals the structural shifts transforming the gold market - and the one economic wildcard that could change everything. 

Investment strategies

Fact, fiction and fission: The future of nuclear energy

Nuclear power is back in the spotlight, including in Australia. For investors exploring the sector, here are four key factors to consider in this evolving energy landscape. 

Taxation

The myth of Australia’s high corporate tax rate

Australia’s corporate tax rate is widely seen as a growth-killing burden. But for most local investors, it’s a mirage - erased by dividend imputation. So why is it still shaping national policy? 

Taxation

Should we change the company tax rate?

The headline 30% corporate tax rate masks a complex system of dividend imputation and franking credits that ensures Australian shareholders are taxed only once, challenging traditional measures of tax competitiveness. 

Investing

Noise cancelling for investors

A lot of the information at an investor's fingertips today has little long-term value. The modern investing greats are not united by access to faster information, but by their ability to filter out what doesn’t matter.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.