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Welcome to Firstlinks Edition 320

  •   19 August 2019
  • 5

Most of you have never used a bond price calculator. It may sound boring but inputting a few yields into this simple calculator provided by the ASX is highly instructive. It shows why bond funds have delivered strong returns in the last year and the possible impact of a reversal if rates rise.

Let's check some prices based on the longest Australian Government bond listed. These examples use 1% movements in rates, which are more likely to take months rather than happening quickly:

1. 3% coupon bond matures 21 March 2047. Current price $133.77, current yield 1.55%.
2. Increase the yield by 1% to 2.55%, same bond, price falls to $108.93.
3. Reduce the yield by 1% to 0.55%, same bond, price rises to $162.72.

Rises or falls of 1% are possible. The US President has made 43,600 tweets (as at last night) since he came into office and the next one could move the market. If we had a share price falling from $163 to $133 or $109 the headlines would scream about volatility. This is a bond (admittedly, the long bond exaggerates the outcome) but a $54 fall from $163 is 33%. A bond will pay $100 on maturity but it can be quite a ride in the meantime, as Warren Bird explained.

If you think 28 years to 2047 is a long time, the US Treasury is canvassing investor appetite for a 100-year bond. Austria issued a 'century' bond in 2017 with a coupon of 2.1% and the yield is now 0.66%, with the price over $200. Who said bonds were boring or riskless?!

It's fun to try inputting a negative yield (and thanks to Peter Morgan for this example).

That's a relief! The ASX says yields cannot go negative. They should tell the Reserve Bank to stop lowering rates or the ASX will need to fix their model. Around the world, almost US$17 trillion of bonds offer negative yields (Source: Bloomberg) from only US$6 trillion less than a year ago.

In this week's edition ...

Exchange Traded Funds (ETFs) are a major factor in the changing landscape of investing, driven by the low cost of indexing and easy access via the listed market. In our continuing Interview Series, Alex Vynokur maps these developments, including in the active and thematic forms, and gives pointers to the ways investing will continue to change.

On the theme of change, Jeremy Podger describes six major themes which will have major impacts on markets in coming years, and Vivek Bommi explains three types of fixed interest alternatives as investors struggle with 1% cash and term deposit rates.

We then have two articles on investor behaviour. Julian Morrison warns investors not to think activity is the best way to invest, while Erica Hall cites research showing many retirees are too frugal and cautious in their desire not to run out of money.

There has been considerable media coverage of the Mercer versus Grattan debate about super and living standards in retirement, and we show both sides of the debate. It's hard to argue that someone earning less than the tax-free threshold of $18,200 who pays 15% tax in super is benefitting from the system as much as someone with a marginal tax rate of 45%.

This week's White Paper from NAB/nabtrade reports on the key findings from their recent seminar on fixed income trends.

Graham Hand, Managing Editor

For a PDF version of this week’s newsletter articles, click here.


August 23, 2019

A very appreciative regular reader wishes to thank Cuffelinks for applying the print function to written articles.

Chris D
August 22, 2019

I love those opening comments Graham.

My gut feel is, you’d be surprised how many people don’t understand the relationship between bond price and rate.

Warren Bird
August 22, 2019

Perhaps Chris D, but my observation (based upon a couple of decades of presenting to audiences on the topic) is that there are more that understand that relationship than those who understand the way bond returns work over the life of the asset. As a result they get far too worried about short term volatility and forget about income, which increases as yields rise provided you either reinvest coupon interest or you own a portfolio of bonds that have maturities to reinvest.

Graham's article is a good lesson in short term volatility, which is a reality of investing in long term fixed income. But I know that Graham also realises that it's not the whole story either, hence his link to my article on the life of a bond.

And in response to James' comment about bond returns being 'assymetric', I don't know that Graham's article actually says that. In the short term, when capital value fluctuations dominate, they're symmetric. Yields up or down, the price change is going to be the duration of the bond times that change. (OK, for pedants like me, if it's a big yield change then it's not exactly symmetric because of convexity, but it's of the right order of magnitude.)

Where bond returns are asymetric is over the long run where they're biased on the upside, because you always have the positive impact of interest income dominating. Well, I suppose negative bond yields make the return assymetric on the downside, but the point is that the yield to maturity is always very close to the total return over the life of the bond. Those symmetric price fluctuations end up washing out by the maturity date of each asset.

August 22, 2019

Nice work on bonds, Graham – good for people to realise how asymmetric bond returns can be.

Warren Bird
August 21, 2019

Personally, I think that the case for investing in fixed income (bonds) with a duration as long as that of equities presumes that you reinvest your income payments so that you get the benefits of compounding. That way, if yields increase after you make the investment, you'll be investing a lot of cash flows back into your portfolio at those higher yields, thus ratcheting the return up well beyond the initial purchase yield.

Unfortunately that ASX calculator - like so much of the bond information that a stock market provider like the ASX gives us - is only a snapshot of 'what if' scenarios at today's date. It doesn't show you how the investment might perform over it's entire life under different assumptions about reinvestment and the future path of the yield at which you make reinvestments. It therefore encourages overemphasis on the price change from a shift in yields as if that was an instantaneous outcome. Graham's example of a 1% change in yields is simply not going to happen in a day, especially on a long term bond. The longer the time period over which the change happens, the more important income accrual and reinvestment become in the final outcome and the less important is the change in price.


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