Tim Hext: In bonds, the trend is your friend

There have been a few false starts in the turning point for the current economic cycle, but now it’s the real deal, says Pendal’s head of government bonds, TIM HEXT

• Focus is shifting from inflation to the labour market.
• Bond yields likely to keep falling
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

CENTRAL banks never use language unintentionally and Federal Reserve chair Jerome Powell has made it very clear that rate cuts are coming, Hext says.

Powell recently used phrases like “the inflation battle is over”, Hext says, and while inflation is always important, it is less important than it was.

“The market will now be more forgiving. A slightly higher number on inflation, or a slightly lower number, won’t move the market as much,” he says.

“The focus now is squarely on employment and unemployment and Powell’s line that the Fed does not ‘seek or welcome further cooling in labour market conditions’ is particularly interesting. He is basically saying the US is at full employment, at a point where it is not inflationary.”

That is a key difference between the US and Australia, and a reason why the Reserve Bank has not indicated a bias towards easing monetary policy.

“It’s hard to put a number on it but the RBA believes full employment in Australia is probably around 4.4 per cent and currently the unemployment rate is 4.1 per cent.”

What does that mean for investors in government bonds?

“It is very difficult to pick the very top or very bottom in yields. What is easier is to look at the trend. Are rates going up or are they going down?” Hext asks.

“When the central bank starts hiking or cutting benchmark rates, the bond market has already moved. But that doesn’t mean the moves in bond yields have gone as far as they are going to go. The changes in benchmark rates continue the trend. They don’t end it.”

“When the Reserve Bank hiked rates in May 2022 the market had been selling off quite aggressively for six months and it continued to sell of afterwards. Right now, there’s been a decent rally for six months and that will continue,” Hext says.

“The point is the trend will keep going and there’s still time to benefit from that.”

In equities trading, price-to-earnings multiples and forward earnings expectations are widely used to determine the “fair value” of a stock. Is there an equivalent in bonds?

“There’s two key anchor points for bonds,” Hext explains.

“One is inflation, and that other is real interest rates. It is a bit definitional because inflation plus a real rate equals a nominal rate, but it tells investors if interest rates are protecting them against inflation.”

Hext says if the Reserve Bank is doing its job, inflation over the long term will be about 2.5 per cent, which provides a starting to point for risk-free government bonds.

To get a real return in excess of the risk-free rate, over the long term, an economy must become more productive, meaning more output per unit of input.

The Productivity Commission estimates that productivity should be around 1.2 per cent long term, meaning a risk-free bond yield of 3.7 per cent is about par.

Hext emphasises these are long run concepts and provide a guide only.

The yield on a ten-year government bond currently is around four per cent, suggesting bonds are fetching more than the long-term average, Hext says.

“If anyone asks what fair value is for a ten-year bond, then that’s as good a guess as any. It looked ridiculous when ten-year bonds were at one per cent and optimistic when they were at five per cent, but it is a long-term concept,” he says.

“It is the sort of analysis people need to undertake if they are, for example, considering a term deposit. Within 12 months you are not going to get a term deposit for a four in front of it, whereas in bond markets, which are liquid, you can buy a semi-government bond at closer to five per cent.”

About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.

Find out more about Pendal’s fixed interest strategies here

About Pendal

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

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