When is the right time to invest in fixed rate bonds?
Investors are constantly seeking the optimal moment to enter the world of fixed-rate bonds. The decision involves a careful evaluation of several factors, including yields, accrual attractiveness, and the impact of potential bond price changes on overall returns. As the financial landscape shifts, understanding when to invest in bonds becomes crucial.
In recent times, the Reserve Bank of Australia has taken active measures to control inflation, resulting in an increase in Australian cash rates to 4.35 percent. Consequently, the accrual on high-grade bonds has experienced an upturn. Of particular note, for the first time in over a decade, five-year major bank senior fixed-rate bonds have surpassed relevant dividend yields.
Historically, the ideal moment to invest in bonds has often coincided with central banks initiating rate cuts. This observation has been a key principle guiding investors, as evidenced by Bloomberg's data.
With Australian 10-year bonds currently at 4.45 percent, a notable 40 basis points higher than their starting point for the year, the bond market has witnessed significant fluctuations throughout this period.
One of the primary attractions of bonds is their safe-haven status. Investors are well aware that unforeseeable events with unpredictable magnitudes can send shockwaves through the financial markets. The events of March this year serve as a stark reminder of the importance of including bonds with insurance-like characteristics in a portfolio.
During this period, despite inflation remaining above 6 percent, a wave of uncertainty prompted investors to seek refuge in safe-haven assets. The collapse of first US regional lender Silicon Valley Bank and subsequently Credit Suisse triggered a sell-off in the stock market, causing the ASX 200 to plummet by 6.4 percent. ASX REITs also suffered, falling by 13 percent, while the S&P 500 recorded a 6.6 percent decline. Australian 10-year government bonds, however, surged by 0.80 percent to reach 3.2 percent, translating into a 4.4 percent return for the month. High-grade non-sovereign bonds also rallied significantly during this period.
Another critical factor in bond investment timing is inflation or disinflation. The tension between tight labour markets and the lagged effects of previous monetary policy changes on inflation has led to wide yield ranges throughout the year. Investors have been closely monitoring data related to fast twitch activity, anticipating a decline in inflation significant enough to prompt the US Federal Reserve to commence rate cuts by year-end.
However, the efficacy of the US cash rate has been compromised due to the majority of mortgages being fixed at historically low rates for extended periods. As a result, long bond yields have remained markedly lower than cash rates, leading to disparities in financial conditions.
Rising oil prices have also played a role in the inflation equation, with prices surging 25 percent over three months following a low point in June. The subsequent increase in the price of petrol added to the cost of transporting goods, impacting the Consumer Price Index (CPI).
In August, 10-year US Treasuries averaged 3.90 percent, only to surge to 5 percent by October. Central banks, including the Federal Reserve, expressed their commitment to further rate hikes. This led to a reassessment of the value of bond accrual, and a sharp rise in bond yields began to erode confidence in extending bond duration. Some investors reasoned that the ideal time to add duration was when central banks initiated rate cuts.
This surge in yields had a tangible impact, as investor confidence waned and financial conditions tightened significantly. This shift skewed the probability of the opportune moment to add duration.
Looking ahead, investors should remain vigilant for a potential shift lower in inflation, as central banks are likely to react accordingly. Lower inflation typically results in lower bond yields and, consequently, higher bond prices. Historical data suggests that the majority of bond rallies occur prior to central banks implementing rate cuts.
If lower prices persist, coupled with diminished wage expectations, the price-wage cycle may adjust downward, significantly impacting the investment landscape.
Drawing a parallel to the past, in 2014, oil prices plummeted by 54 percent between June and December. In response to this disinflationary pulse, the Reserve Bank of Australia (RBA) resumed an easing cycle, cutting cash rates to 2.25 percent at the February 2015 meeting. However, 10-year bonds experienced only a marginal rally, increasing by 0.15 percent to reach 2.30 percent, resulting in a 1.9 percent return over the period. It's worth noting that prior to the RBA easing, these bonds had already fallen by 130 basis points from August 2014 to the February rate cut, yielding a 12.7 percent return due to the disinflationary pulse that prompted monetary easing.
In today's context, as global economic activity weakens and additional supply saturates the market, oil prices have experienced a 20.3 percent decline since September. Should this trend persist, it could contribute to a disinflationary pulse that prompts central banks to take action.
US Treasury yields have fallen approximately 50 basis points from their October peak, with Australia witnessing a somewhat larger decline.
The lag between the drop in global oil prices, its impact on petrol prices at the pump, and subsequent CPI data suggests that there may still be more room for the disinflationary pulse to influence bond markets.
In summary, while local factors such as rental inflation and the current hawkish stance of the RBA are essential considerations, it is imperative to recognize the broader global factors that influence local markets. Accrual value, safe-haven status, and the potential for a disinflationary pulse all play pivotal roles in determining the opportune moment to invest in fixed-rate bonds.
As we enter 2024, investors would do well to keep a close watch on these factors, as they may hold the key to successful bond investments in the coming year.
Peter Milios is a recent graduate from the University of Technology - majoring in Finance and Accounting. Peter is currently working under equity research analyst Di Brookman for Corporate Connect Research.