Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 384

Bond basics and four messages in the search for yield

Bonds have been strong performers over more than a decade in the lead-up to the current crisis, and we believe they could play an important part in defensively-positioned portfolios in future. While there is a certain lack of understanding about bonds on the part of many investors, relative to equities, but the principles are quite simple. Here are a few things we bear in mind when considering a role for bonds in a portfolio:

1. Income and defensive positioning

An important part of building a defensive position into a portfolio is the inclusion of securities with cash flows that are resistant to market downturns. Considering the credit risk of the issuer, bonds can offer an opportunity to harvest regular and reliable income streams with lower risk of capital instability.

2. Returns are typically driven by interest rate sensitivity

As interest rates fall, the discount factor used to value income streams is reduced, increasing the value of those cash streams today. The yield on issued bonds becomes more attractive, driving up prices and returns.

The sensitivity of a fixed income security’s price to changes in yield increases the further a bond is from its maturity. When measuring how sensitive a bond’s price is to changes in interest rates, we refer to its duration (as explained below). 

The strong performance of bond markets over the past decade has been driven by a falling interest rate environment, fuelled by a series of financial crises and the lack of ability on the part of most major economies to generate significant inflation, in turn necessitating monetary stimulus in the form of lower interest rates. In this environment, portfolios with higher duration have tended to perform strongest.

The gains on offer from interest rate risk have plateaued in recent years as interest rates across most of the developed world have effectively bottomed out, and it’s important for investors holding these assets to understand the specific role they play in their portfolio structure.

3. Investment-grade credit can play a defensive income role

Credit spreads are the difference between yields on non-government bonds such as corporate bonds and government bonds, and represent the additional credit risk premium allocated to the issuer of the bond. Credit spreads widened dramatically during the first stages of COVID-19, as passive bond funds underwent forced selling and introduced excess liquidity into the market. Over the past few months, however, spreads have largely stabilised towards pre-COVID levels, particularly in investment-grade bonds.

Despite this, investment-grade credit spreads tend to have a fairly low volatility, and well-constructed portfolios may provide access to this credit risk premium for a low level of downside risk. We find that through the cycle, investors in Australian investment-grade bonds tend to be overcompensated for the credit risk they are taking. By investing into a diversified portfolio of stable investment-grade bond issuers, investors may earn superior risk-adjusted returns, and do so without seeing undue volatility in the total returns they earn from these investments. In an environment of very low yields globally and where investors are being tempted down the quality spectrum to earn moderate returns, we view this as a key means of earning defensively oriented income in an uncertain environment.

4. The outlook for Australian investment-grade bonds remains positive

Australian companies were better prepared for this crisis than their counterparts in countries such as the US. We believe Australian corporates entered the recession with stronger and more conservatively positioned balance sheets and were quick to raise equity where they faced uncertainty. This supportive attitude has been reflected in ratings, and our corporate sector has for the most part avoided the ballooning leverage witnessed in other markets.

That said, there are still considerable downside risks ahead relating to the future evolution of the pandemic and the capacity for our economy to recover. Uncertainty is likely to persist for some time, especially with the risk of further waves and lockdown.

Despite this potential volatility, inflation and interest rates are likely to remain low in the short to medium term, and future stimulus programs should remain highly supportive of credit markets. We view a well-constructed portfolio of defensive income in this space as being a critical component for weathering this uncertain economic environment.

Decoding the corporate bond discussion

The key to understanding bonds is becoming fluent in the terminology used to describe the various attributes of fixed income securities. Let’s take a run through a few of the more important concepts.

Types of yield

Current yield, also known as running yield, refers to the annual payout as a percentage of the current market price. For example, the current yield on a bond with a market price of $1,000 that pays $80 per year in interest is 8%. Running yield is a similar concept to the dividend yield for equities.

Yield to maturity, or gross redemption yield, is a yield that represents the total coupon payments for that bond if held to maturity, plus interest on interest (the reinvestment), and the gain or loss realised from the security at maturity.

A yield curve is a function that traces relative yields on a type of security against a spectrum of maturities ranging from three months to 30 years or longer.

The next consideration is the way that yield responds to interest rate movements and credit risk.

Interest rate sensitivity

We use the term duration to broadly refer to the extent to which a bond’s pricing responds to interest rate movements. Technically, it’s a weighted measure of the amount of time until the cashflows of the bond are received (Macaulay duration). As such, it reflects the timing and magnitude of each cash flow, and the extent to which changes in the discount rate for those cash flows (at the prevailing interest rate) will affect the price of the bond.

Modified duration is an extension of the Macaulay duration concept, whereby it directly expresses the percentage change in the price of a bond for a given change in interest rates.

Credit sensitivity

Credit risk is the expected risk of loss due to the issuer delaying or defaulting on interest or principal payments. Credit risk is assessed by agencies who issue credit ratings on the quality of debt securities.

Bond issuers with lower credit ratings must pay a premium to investors who purchase their bonds. The difference between the yield on a bond and a government bond of the same maturity (effectively a risk-free rate of return) is known as the credit spread, measured in basis points.

Credit spreads are affected by factors such as the financial strength of the issuer, broader macroeconomic conditions and the demand and supply amongst investors for the issuer’s securities. After purchasing a corporate bond, the bondholder may benefit from a narrowing of the credit spread which all else being equal, should drive up the price of the bond, delivering a capital gain.

In a similar fashion to interest-rate sensitivity, the term credit spread duration is used to refer to the sensitivity of a bond’s price to movements in credit spread. Typically, the higher the credit spread duration in a portfolio, the greater the credit risk that investors are exposed to.

Understanding corporate bonds, or fixed income generally, does not need to be complicated. Once the basic principles are broken down, investors can better understand how corporate bonds may perform in a changing interest rate and macroeconomic environment.

 

Nathan Boon is Head of Credit Portfolio Management and Co-Portfolio Manager at AMP Capital, a sponsor of Firstlinks. This document has been prepared for the purpose of providing general information, without taking account of any investor’s individual objectives.

For more articles and papers from AMP Capital, click here.

 

4 Comments
Mark
November 20, 2020

Thanks Warren, this is very helpful.

Warren Bird
November 20, 2020

At the risk of tooting my own horn, perhaps some of my articles can help with Mark and Stella's questions.

This one has what I hope is a straightforward explanation of duration - check out the last section in particular: https://www.firstlinks.com.au/term-deposit-investors-did-not-understand-the-risk

This one provides some info on yield to maturity: https://www.firstlinks.com.au/bond-funds-and-term-deposits-are-apples-and-apples

Or this one which discusses how duration and yield work together over time: https://www.firstlinks.com.au/journey-life-fixed-rate-bond

And in anticipation of other questions, here's an article I wrote that responded to a reader's questions a few years back, but probably still relevant: https://www.firstlinks.com.au/bond-questions-answered

I urge Nathan, and all fixed income investors, to work a little bit harder to make this wonderful asset class accessible. The concepts that we take for granted as fund managers are too often explained in purely technical terms and that just scares people. I know that's not the intention, but if you're going to market something you have to make people feel comfortable, not confronted.

Mark
November 19, 2020

Thanks Nathan, this is a good article. Would you also be able to provide an example of yield to maturity workings for a hypothetical bond?

Stella
November 19, 2020

You lost me with 'duration'. An example, please?

 

Leave a Comment:

     

RELATED ARTICLES

Are we going through a 'bond market rout'?

Are you in fixed interest for the duration?

banner

Most viewed in recent weeks

Five ways the Retirement Review points to new policies

The Retirement Income Review goes much further than an innocent-sounding 'fact base', and is sure to guide policies in the run up to the next election. It will change how we think about retirement incomes.

Graeme Shaw on why investing is at a pivotal moment

Company profits have not improved for many years but higher valuations have been driven by falling rates and excess liquidity. Conditions do not suit a value and contrarian manager but here are some opportunities.

Retirement Review gives strong views on hoarding of super

The Review includes some profound findings, most notable that retirement income should include drawing down far more capital. Expect post-retirement products to proliferate under a Retirement Income Covenant.

11 key findings on retirement dreams during the pandemic

A mid-pandemic survey of over 1,000 people near or in retirement found three in four are not confident how long their money will last. Only 18% felt their money was safe during a strong economic downturn.

Bank scorecard 2020: when will the mojo return?

Banks severely cut dividends in 2020 but are expected to improve payments in 2021. History provides clues to when the banks will return to their 2019 levels of profitability, but who is positioned the best?

Generational wealth transfers will affect all investors

It's not only that 60 is the new 40, but 80 is the new 60. Many Baby Boomers spend up in retirement and are less inclined to leave a nest egg to their children. The ways wealth transfers will affect all investors.

Latest Updates

Retirement

Five ways the Retirement Review points to new policies

The Retirement Income Review goes much further than an innocent-sounding 'fact base', and is sure to guide policies in the run up to the next election. It will change how we think about retirement incomes.

Property

Steve Bennett on investing in direct property for the long term

As people stayed home during the pandemic, a bearish view swept over most property sectors, but many have thrived and prices have recovered rapidly. The best opportunities are in long leases with quality tenants.

Retirement

Retirement Review gives strong views on hoarding of super

The Review includes some profound findings, most notable that retirement income should include drawing down far more capital. Expect post-retirement products to proliferate under a Retirement Income Covenant.

Superannuation

Paul Keating on why super relies on “not draining the bath”

Paul Keating is the champion of compulsory superannuation as the central means of funding retirement. In the wake of the Retirement Income Review, he is at his passionate best defending the system, with Leigh Sales.

Latest from Morningstar

Is your portfolio too heavy on technology stocks?

Investors with heavy allocations to a broad US index should check how much is exposed to tech stocks, especially when valuations look a bit steep. It might be time to reallocate to other sectors or styles.

Investment strategies

Beware of burning down the barn to bury the debt

At some point, policymakers will turn to the task of deleveraging, to work off massive debt burdens built up during the pandemic. Australia is already ticking the boxes on many policies used in the past.

Superannuation

New bankruptcy rules may have a domino impact on SMSF pensions

During COVID, bankruptcy rules have allowed small businesses to trade while insolvent. It may mean an SMSF is hit by the collapse of a business leaving trustees struggling to meet their own legal obligations.

Sponsors

Alliances

© 2020 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.
Any general advice or class service prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, has been prepared by without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information. 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.