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

Pros and cons of Labor's home batteries scheme

Labor has announced a $2.3 billion Cheaper Home Batteries Program, aimed at slashing the cost of home batteries. The goal is to turbocharge battery uptake, though practical difficulties may prevent that happening.

Howard Marks: the investing game has changed

The famed investor says the rapid switch from globalisation to trade wars is the biggest upheaval in the investing environment since World War Two. And a new world requires a different investment approach.

Welcome to Firstlinks Edition 606 with weekend update

The boss of Australia’s fourth largest super fund by assets, UniSuper’s John Pearce, says Trump has declared an economic war and he’ll be reducing his US stock exposure over time. Should you follow suit?

  • 10 April 2025

4 ways to take advantage of the market turmoil

Every crisis throws up opportunities. Here are ideas to capitalise on this one, including ‘overbalancing’ your portfolio in stocks, buying heavily discounted LICs, and cherry picking bombed out sectors like oil and gas.

An enlightened dividend path

While many chase high yields, true investment power lies in companies that steadily grow dividends. This strategy, rooted in patience and discipline, quietly compounds wealth and anchors investors through market turbulence.

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

Latest Updates

Investment strategies

Getting rich vs staying rich

Strategies to get rich versus stay rich are markedly different. Here is a look at the five main ways to get rich, including through work, business, investing and luck, as well as those that preserve wealth.

Investment strategies

Does dividend investing make sense?

Dividend investing offers steady income and behavioral benefits, but its effectiveness depends on goals, market conditions, and fundamentals - especially in retirement, where it may limit full use of savings.

Economics

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

Strategy

Ageing in spurts

Fascinating initial studies suggest that while we age continuously in years, our bodies age, not at a uniform rate, but in spurts at around ages 44 and 60.

Interviews

Platinum's new international funds boss shifts gears

Portfolio Manager Ted Alexander outlines the changes that he's made to Platinum's International Fund portfolio since taking charge in March, while staying true to its contrarian, value-focused roots.

Investment strategies

Four ways to capitalise on a forgotten investing megatrend

The Trump administration has not killed the multi-decade investment opportunity in decarbonisation. These four industries in particular face a step-change in demand and could reward long-term investors.

Strategy

How the election polls got it so wrong

The recent federal election outcome has puzzled many, with Labor's significant win despite a modest primary vote share. Preference flows played a crucial role, highlighting the complexity of forecasting electoral results.

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.