Bond yields have increased sharply in the last 12 months and anticipated investment returns are at levels not seen for more than a decades writes Pitcher Partners principal Andrew Wilson
Managing an investment portfolio is not unlike wielding a cricket bat – there are scenarios when aggressive methods are necessary to generate good returns and others that require a more circumspect approach.
As the economic conditions change in Australia and around the world, there is a strong argument for going on the defensive in order to keep the investment scoreboard ticking over.
The advantages of government bonds are well known – they are securities that have a low risk of permanent impairment and they provide a degree of insurance against a downturn in the economy, which is often preceded by a fall in share markets.
The Reserve Bank of Australia’s (RBA) actions are pushing interest rates up for all fixed-interest securities and within this asset class, government bonds represent the highest quality bonds as they have the lowest likelihood of default.
The difference now is that bond yields have increased sharply in the last 12 months and anticipated investment returns are at levels not seen for more than a decade.
State of play
To understand why we first need to understand the current state of play.
Australian equities continued to rally in January and employment remains strong. Unemployment is expected to rise slightly over the next 12 months to around 4.1%, but coming from the current level of 3.5% seasonally adjusted, unemployment remains historically low.
The RBA expects the high rate of inflation to gradually decline later in the year due to both global factors and slower growth in domestic demand, which may mean the end of the interest rate hiking cycle.
Australia’s cash rate now sits at 3.35% but the RBA has now tempered its cash rate forecast and anticipates that it will peak between 3.5% to 4% around September this year, followed by interest rate cuts to stimulate the economy again.
Global share markets also enjoyed strong returns in January, including the S&P 500 which returned 6.2% (currency hedged). Investors were buoyed by the narrative that the Federal Reserve may soon be cutting interest rates and US employment levels remained strong, which supports consumer spending and encourages business investment.
The reopening of China’s economy after the abandonment of its zero-COVID policies has also been welcomed.
Why defensive?
So, amid these positive signs, why would we be thinking defensive?
Economic data in Australia is beginning to show signs of a slowdown in activity, due to a combination of factors. Consumer confidence is only a fraction above where it was at the start of the COVID-19 lockdowns in April 2020, while retail sales fell for the first time in more than a year.
More broadly around the world, there are indications that suggest weaker economic growth, which would be a negative for share markets. While still raising rates, the US Fed has slowed the pace of rate hikes and indicated that it did not see financial conditions as excessively loose.
This means it is now harder for businesses and consumers to access capital, which reduces the case for further large interest rate increases. Inflationary forces remain high, although they appear to be decelerating, and that could lead to central banks pausing interest rate hikes in the months ahead.
The US Federal Reserve and European Central Bank have continued hiking interest rates in recent weeks, actions that are raising borrowing costs and which will eventually reduce consumer spending and business investment.
In light of this environment, diversified investors may consider adding government bonds to their portfolio.
Consider ‘neutral rate’
Over the last 20 years, the yield on a 10-year Australian government bond has averaged 0.58% above the RBA cash rate – if this premium is applied to the current cash rate of 3.35%, we expect bond yields to be around 3.93%.
However, it is worth considering that the RBA is currently in a tightening cycle to dampen demand and changes to this cycle may affect bond yields, which is why investors should also consider the ‘neutral rate’.
The neutral rate is the cash rate which neither stimulates nor restricts demand. While it is somewhat hypothetical, the RBA’s Assistant Governor Luci Ellis estimates the neutral rate to be around 2.5% in nominal terms. If we again apply the 0.58% premium, then 3.08% is a reasonable yield for Australian government bonds.
Over the last three months, the yield on 10-year government bonds has been fluctuating between 3.5% and 4%, which represents a reasonable entry point in our opinion.
Whether government bonds are appropriate will depend on a range of factors unique to an investor including risk tolerance, other assets owned and their portfolio objectives.
However, fixed-income investments are as attractive as they have been for the last decade and if investors have concerns about the economic environment, a defensive strategy may be the best form of attack.
