Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 220

Why the times suit active fixed interest

It is hard to believe, but back in August 1982, the Australian cash rate averaged 17% (the unofficial rate went as high as 19%) and the yield on a 10-year Australian government bond was 16.5%. Some 35 years later, the cash rate is 1.5% and the yield on a 10-year government bond is around 2.6%.

Over this period, the Australian fixed interest sector has been in a structural bull market, propelled by the shift from a high to low inflation environment and demographic factors which lowered real rates. More recently, conventional and unconventional monetary easing has driven yields even lower.

For investors in the sector, the last 35 years have generated handsome returns, even allowing for the 1994 bond bear market. Returns of 9.5% p.a. compare favourably to 12% p.a. from the Australian share market and 7.6% p.a. from cash over this period.

Source: Chart 1: Bloomberg, as at 30 July 2017. Chart 2: Source: Janus Henderson Investors, Bloomberg, Ausbond Indices, UBS, SBC Brinson. Spliced history of Australian Bond market returns. As at 30 June 2017. Forecast numbers are estimated projections only. ^CYTD 2017.

Beware the bull complacency trap

A common trap that investors can fall into is becoming complacent about the risks that may be building up in their sector exposures after a prolonged period of structural change and good returns.

With the global economy enjoying a cyclical recovery and central banks signalling a desire to begin withdrawing high levels of policy accommodation, investors’ attention should focus on two sources of risk embedded in the sector benchmark, the Bloomberg AusBond Composite 0+ Yr Index (benchmark) that have built up progressively since the GFC.

Lengthening benchmark duration = more interest rate risk

Just because the level of interest rates is low by historical standards does not mean that a small rise in rates will have a limited impact on sector returns. Investors need to be aware that since 2009, the duration (a measure of maturity term) of the Australian fixed interest sector has risen from around three years in mid-2009 to around five years currently.

In 2009 when bond market yields averaged around 5.5% and duration was three years, investors’ exposure to interest rate risk was such that a 1% rise in bond yields would have resulted in capital loss of 3%, delivering a total return of around 2.5% (i.e. the income of 5.5% minus the capital loss of 3% from rising bond yields).

Today, with average bond market yields of around 2.5% and the duration of the benchmark around five years, a 1% rise in bond yields would result in capital loss of 5% delivering a total return of -2.5% (i.e. 2.5% income less 5% capital loss). A 0.5% lift in yields would result in flat returns (i.e. 2.5% income less 2.5% capital loss).

Chart 3: Australian average bond market yield and modified duration

Source: Bloomberg, as at 11 August 2017. Date is monthly to December 2016, daily from January 2017. Australian bond market based on the Bloomberg AusBond Composite 0+ Yr Index.

With the RBA Governor indicating that the next move in rates is likely to be up, investors need to be mindful of the interest rate risk in the sector benchmark. Over the last few years, investors in passive fixed interest products have enjoyed a good run as interest rates fell and the duration of the benchmark lengthened.

Looking ahead, investors in such strategies need to be aware of their exposure to capital loss from even modest rises in rates. By way of example, the yield to maturity on the benchmark lifted from 1.98% at the end of July 2016 to 2.43% at the end of July 2017. With the duration of the benchmark at historically high levels, resultant capital loss more than offset any income, with returns down 0.24% over the period.

We believe active fixed interest strategies or absolute return strategies, where managers are not bound to hold duration at benchmark levels, are better positioned to preserve investors’ capital in a rising rate environment.

Benchmark compositional risk: lower-returning government debt, less diversification

Since the GFC, there has been significant change to the composition of the Australian fixed interest benchmark. The heavy issuance of increasingly longer-dated government debt (federal, state, supra national) combined with corporate deleveraging has hastened the ‘crowding out’ effect in the benchmark. As a result, the market weight of the higher-yielding credit sector in the benchmark has fallen from 36% in 2008 to around 8% in 2017 currently.

Investors in passive index strategies have progressively lost access to both the higher yields available in the credit sector and diversification benefits of broader holdings in the benchmark. Longer-dated government debt has increased the interest rate risk. The past year highlights the importance of active interest rate management in navigating the gradual reversal of the bond bull market.

Jay Sivapalan is Portfolio Manager, Fixed Interest at Janus Henderson Investors.

Warren Bird
September 21, 2017

I'm going to sound like a broken record, but the attractive returns have not been because of falling yields or 'a bull market'. Bond market returns have actually declined because of falling yields. The hint is in the article itself - at the start of the 35 year period ten year bonds paid an annual return of 16.5%. That the average return over the 35 years since has been only 9.5% is because yields declined through time. If we hadn't had this alleged "bull market" we'd have had average returns over 35 years of 16.5%.

I do have sympathy with the general premise of the article, because it's unusual for any bond index to align closely with investor risk preferences for term or default risk composition. But the old 'structural bull market' argument is not only not necessary for making the case, it's actually factually incorrect that such a thing has happened.

The flip side is that, though bond yields are now only around 2.5%, if they rise over the next decade or two or three, bond returns will increase. All the fear about how 'bad' it will be for investors if rates go up will be long forgotten then - the short term decline in capital values will be swamped by increased reinvestment income and higher coupons down the track.

Perhaps you need a career that has spanned a 35 year period to be able to take a 35 year view like I do, but I can honestly say looking back over 1982-2017 that all the short term bull and bear markets in bonds are just noise. The driver of the returns from this asset class is income, not capital.

Yes, active managers in theory should "preserve capital" in a rising rate environment - and bravo if you do. But my memory of, say, the 1994 bond sell-off is that the biggest mistake active bond managers made was that they didn't go long duration again at 10% yields in 1995. Looking back, the income foregone by not jumping on board then was far more significant than the short term capital lost by not having been short in 1994.


Leave a Comment:


Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Three all-time best tables for every adviser and investor

It's a remarkable statistic. In any year since 1875, if you had invested in the Australian stock index, turned away and come back eight years later, your average return would be 120% with no negative periods.

The looming excess of housing and why prices will fall

Never stand between Australian households and an uncapped government programme with $3 billion in ‘free money’ to build or renovate their homes. But excess supply is coming with an absence of net migration.

Five stocks that have worked well in our portfolios

Picking macro trends is difficult. What may seem logical and compelling one minute may completely change a few months later. There are better rewards from focussing on identifying the best companies at good prices.

Let's make this clear again ... franking credits are fair

Critics of franking credits are missing the main point. The taxable income of shareholders/taxpayers must also include the company tax previously paid to the ATO before the dividend was distributed. It is fair.

Welcome to Firstlinks Edition 424 with weekend update

Wet streets cause rain. The Gell-Mann Amnesia Effect is a name created by writer Michael Crichton after he realised that everything he read or heard in the media was wrong when he had direct personal knowledge or expertise on the subject. He surmised that everything else is probably wrong as well, and financial markets are no exception.

  • 9 September 2021

Latest Updates

Investment strategies

Joe Hockey on the big investment influences on Australia

Former Treasurer Joe Hockey became Australia's Ambassador to the US and he now runs an office in Washington, giving him a unique perspective on geopolitical issues. They have never been so important for investors.

Investment strategies

The tipping point for investing in decarbonisation

Throughout time, transformative technology has changed the course of human history, but it is easy to be lulled into believing new technology will also transform investment returns. Where's the tipping point?

Exchange traded products

The options to gain equity exposure with less risk

Equity investing pays off over long terms but comes with risks in the short term that many people cannot tolerate, especially retirees preserving capital. There are ways to invest in stocks with little downside.

Exchange traded products

8 ways LIC bonus options can benefit investors

Bonus options issued by Listed Investment Companies (LICs) deliver many advantages but there is a potential dilutionary impact if options are exercised well below the share price. This must be factored in.


Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

Investment strategies

Three demographic themes shaping investments for the future

Focussing on companies that will benefit from slow moving, long duration and highly predictable demographic trends can help investors predict future opportunities. Three main themes stand out.

Fixed interest

It's not high return/risk equities versus low return/risk bonds

High-yield bonds carry more risk than investment grade but they offer higher income returns. An allocation to high-yield bonds in a portfolio - alongside equities and other bonds – is worth considering.



© 2021 Morningstar, Inc. All rights reserved.

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 ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). 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.

Website Development by Master Publisher.