Written by Capital Markets Specialist, Jessica Lin and Head of Capital Markets & Fixed Income, James Williams
The year of 2023 was characterised by global central banks fighting inflation, and outright yields in investment grade bonds rising to be at or close to 20 year-highs. With yields compressing in other asset classes, investment grade fixed income returns have once again become competitive.
As markets adjust to the reality of higher long-term interest rates and persistent inflationary pressures, bonds have once again regained their relevance, underscoring the important role this asset class plays in investment portfolios. As well as potentially protecting portfolios from geo-political shocks and economic downturns, fixed income can generate a stable income for investors, and is currently delivering a baseline annual yield of 5-7%.
In this article, we demystify fixed income and explain some of the concepts that investors should be aware of when investing in this part of the market. These include duration and convexity, as well as issuer creditworthiness and capital structure.
Unlike equity investors, bond investors expect their principal to be returned on a certain date or on maturity of the bond. As long as the issuer is creditworthy, the issuer will continue to pay interest to the investor until the bond matures, and then return the initial principal at maturity with a final interest payment. However, some issuers, like the Australian Government, borrow for a 10-year period or even a 30-year period. So, theoretically, an investor could be waiting 30 years to get their money back (unless they opt to sell the bond in the secondary market). Even though the Government is a very creditworthy borrower, there is an opportunity cost to waiting for capital. That is why an important consideration with bond investing is duration. Bond duration measures the sensitivity of a bond’s price to interest rate changes. It seeks to quantify the bond’s interest rate risk based on a number of factors, including maturity, coupon, yield and call features.
One of the main factors in pricing a bond is that time equals risk. The greater the duration of the bond, the greater its volatility and sensitivity to interest rates. Put another way, if a bond has a higher duration, the investor will need to wait longer for the majority of their cash flows. This means that as interest rates rise, the price of a bond will fall more.
As interest rate expectations move, the component of a fixed-rate bond that will fluctuate is its price.
The coupons on fixed-rate bonds are ‘fixed’ at issue and provide a fixed amount of interest until maturity. This means that as interest rate expectations move, the component of a fixed-rate bond that will fluctuate is its price.
In this example, we compare the NAB 3.225% subordinated Tier II bond with three years to call, the ANZ 5.888% bond with five years to call, and the Westpac 7.199% bond with 10 years to call. With a 1% change in interest rates, the capital price impact is magnified on the 10-year bond versus the three-year bond. Imagine the capital price impact on a 30-year government bond! This is why investors need to be mindful of their own investment horizon. An investor with a 30-year investment horizon could tolerate the mark-to-market loss in the interim, but an investor with a shorter investment horizon may need liquidity before maturity and may be at risk of being forced to sell at a capital loss.
A bond’s duration is continually decreasing as it gets closer to its maturity date. For this reason, it is important an investor actively manages their portfolio and monitors its maturity profile.
Another important concept in bond investing is convexity. Bond convexity is a measure of the non-linear relationship of bond prices to changes in interest rates. Essentially, all else being equal (i.e., without any change in credit risk), a decrease in a bond’s yield will provide investors with more upside on the capital price, while an increase in the bond’s yield will protect investors on the downside. This means that the capital price will decrease less as the yield increases. An example of this is shown in the dollar price changes in the table above. With the NAB three-year bond, a 2% increase in interest rates results in a $4.76 decrease in the bond’s price, while a 2% decrease in interest rates results in a $5.07 increase in the bond’s price.
A further concept to understand is that the duration of a bond changes as coupons are paid to the investor over the life of the bond. This means that if an investor bought a five-year bond at issue and held it for one year, the bond would now have a four-year maturity profile. So, a bond’s duration is continually decreasing as the bond gets closer to maturity. For this reason, it is important an investor actively manages their portfolio and monitors its maturity profile to keep moving up the curve.
In the example on the next page, we have taken the ANZ 5.888% subordinated Tier II bond with five years to call and demonstrated how the coupon and capital price profile change over the life of the bond. Assuming a call on 16 January 2029, the table shows how the capital price changes with every 1% change in yield. In the later years, the price of the bond starts to move towards par as it gets closer to the call date. As such, to actively manage a portfolio, an investor should start looking at opportunities for reinvestment and ‘switch’ into a longer duration bond that may offer a higher return in the one or two years preceding the call date.
Aside from understanding how the pricing of a bond works, an investor should also analyse whether the issuer will likely be able to pay coupons and repay the principal at maturity.
The benefit of higher interest rates is that long-term bond yields will remain higher for investors. As such, the decision to add duration to a portfolio depends on the investor’s view of the current interest rate cycle and whether they believe interest rates have peaked. If an investor believes central banks will start to cut interest rates later this year, then it may be worthwhile to add duration to a fixed income portfolio and lock in coupons at current rates. However, it is important to be mindful that there may be some near-term mark-to-market losses in the portfolio if there are unanticipated interest rate rises that have not been priced in by the market.
With rates now higher, and major banks offering 12-24-month term deposits at around 5% per annum, term deposits are now more attractive than they have been for a long time. As such, some investors are asking why they should park their cash in anything other than a term deposit. The response is, what happens when the investor gets their money back in 12 months? Will they be able to re-invest at the same rate?
What many investors don’t realise is a term deposit is like a short-term fixed-rate bond. Banks pay interest and return principal (or the deposit) to the investor at the end of the term. At the same time, banks are also borrowing from investors via senior unsecured bonds for three to five-year terms in the wholesale over-the-counter market at similar rates. The key difference between the term deposits and fixed-rate bonds is that the latter can be issued for a longer term. While the market prices in the need for interest rates to remain higher for longer, we believe it is attractive to lock in some duration via fixed-rate bonds, as currently investors can lock in 5-7% for the next five to 10 years with investment grade fixed-rate bonds.
The decision to add duration to a portfolio depends on the investor’s view of the current interest rate cycle and whether they believe interest rates have peaked.
If an investor is worried about capital loss from future interest rate rises, then adding more floating rate bonds to the portfolio is an option. The coupon rates on floating rate bonds adjust with the cash rate and protect an investor from interest rate risk. This means that if interest rates increase, the coupons on floating rate bonds will increase. However, this approach will not protect an investor from credit risk. If an investment has been made in a company with a high debt load, the issuer may struggle to meet repayments as interest rates increase and default on the coupon payments. We have a preference for investment grade issuers for this reason.
Fixed income is a defensive asset class and credit investors are focused on downside risk. Aside from understanding how the pricing of a bond works, an investor should also analyse whether the issuer will likely be able to pay coupons and repay the principal at maturity. Much of this depends on the company’s cash flows and where the investor sits in the capital structure.
As the following diagram shows, the type of debt an investor holds (senior or subordinated), will determine the order of creditor payment in the event of a default or bankruptcy. As an example, major banks issue senior secured debt, senior unsecured debt, subordinated Tier II debt, additional Tier I hybrids, and equity. If an investor holds subordinated debt and if the issuer were to default, the investor would only be paid once the claims of senior debt holders have been met. However, that investor would rank ahead of equity holders, who are only paid once all other creditors have been paid.
The liquidity of a bond is dependent on a number of factors. Generally, the larger the issue size, the more liquidity there will be. The government and supra bond market are the most liquid segments of the fixed income market. Outside of government bonds, financials (including the banks) are the most active issuers in this market because of their wholesale funding requirements. In the investment grade market, there are a number of corporate issuers who also meet the investment grade rating, but they are not frequent issuers and may be slightly more expensive due to their ‘rarity’ factor.
In terms of gaining exposure to the most liquid bonds, institutional investors and market participants, including LGT Crestone, predominantly trade in the over-the-counter (OTC) market. The Australian OTC bond market is $2.75 trillion in size. Bonds purchased in the OTC market are cleared through Austraclear (where parcel sizes are a minimum of $500,000) and Euroclear (where parcels can be smaller than $500,000, providing the security meets the minimum bond denomination).
Primary transactions also occur via the OTC market and can be executed quickly in just a few hours. As bonds are physical assets, once a deal has been allocated, unless there is liquidity in the secondary market, it may be difficult to find a parcel to buy! To build a fixed income portfolio it is, therefore, worthwhile bidding into primary transactions and purchasing bonds in the secondary market. Primary transactions also include a new issue concession from issuers, but may be subject to scaling.
While the market prices in the need for interest rates to remain higher for longer, we believe it is attractive to lock in some duration via fixed-rate bonds. As there is no guarantee that yields will be where they currently are in 12 months, we believe it is better for investors to lock in 5-7% for the next five to 10 years with investment grade fixed-rate bonds, rather than investing in 12-24-month term deposits that are offering around 5% per annum.
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