The Point

Fixed interest: why bonds look promising and how to take advantage

A re-assessment of fixed income securities and yields — and their defensive qualities — have recently made bonds attractive again, says Dale Pereira, who heads up client solutions at Pendal.

“Bond returns don’t predict the future — they reflect what’s happened,” says Dale.

“That’s where the opportunity lies: they may be showing negative returns now, but the future looks a lot brighter.”

Bonds typically lead equities in terms of market reaction, says Dale.

“From the end of 2021 and into the first half of 2022, bond yields moved in line with expectations of future rate rises — which in turn reflected inflation expectations.

“But markets often over-react when extrapolating good and bad news. And that’s probably the case now.

“The market has likely priced in too many rate rises. It’s priced in a good chance that central banks won’t be able to control inflation. (Though recently that pricing has started to dissipate, making yields less volatile.)

“This means the bond market is at a much better entry point for investors.”

Amy Xie Patrick: The value proposition for bonds right now

Investors have been hesitant to include bonds in portfolios in recent years — but that’s changing, says Pendal’s head of income strategies, Amy Xie Patrick.

“The bond story of recent years has been flipped on its head. Buying 10-year government bonds in Australia can get you nearly 4 per cent. At the height of the pandemic, it was 50 basis points.

“Now the credit risk-free rate is 4 per cent, which raises the bar for other asset classes.”

Is 4 per cent a good return, given inflation is currently higher than that?

“Inflation markets infer that over 10 years inflation will average around 2.5 per cent, which is the RBA’s inflation target,” Amy says.

“Ten-year bonds are yielding a nominal rate of 4 per cent. By owning a 10-year Australian bond, you are taking effectively no credit risk, keeping up with the 2.5 per cent long-term rate of inflation and then getting another 1.5 per cent.

“You’re getting paid to own something without credit risk and keep up with inflation.”

Tim Hext: RBA heads back to neutral. But where is neutral?

The Reserve Bank considers a neutral rate around 2.5% and a bit. But how much is the bit?

“The concept of a neutral cash rate is very fluid,” says Pendal’s head of government bond strategies Tim Hext.

“The best notion is a rate that reflects long-term inflation expectations plus any adjustment for productivity.

“That is, you should expect your cash returns through the long-term cycle to keep pace with inflation and (assuming positive productivity) deliver some small extra return.

“This leads to the notion of 2.5% (the RBA target) plus a bit.”

The size of that “bit” depends on productivity. Strong business lending and new, Covid-driven efficiences are positive signs for productivity.

Against this are the challenges of reduced globalisation and sustainable energy.

TIM HEXT: Inflation noise gets louder but real yields move markets

How to think about high-yield bonds right now

The jump in bond yields this year has been stark, particularly in the high-yield end of the market.

US double-B rated bonds, for example, yielded 3.2% at the start of the year and are now around 6%.

Is that enough to look at high-yield investments, given the risk-reward trade-off?

“Fixed income is, in our view, certainly much more investable today than it’s been for a while,” says Bill Bellamy, who heads up income strategies at Pendal’s US-based investment manager TSW.

“But we’re probably not totally done with this corrective phase and there is still room to go with yields. As they rise, there are going to be some very good opportunities.”

High-yield bonds can provide an income cushion not available with investment grade bonds, says Bill.

But investors need to analyse the underlying credits ultimately going into a portfolio – not just for safety but to unveil mis-priced assets, he says.

Labor won’t bring big change on the economic front

After the evolution of Coalition fiscal spending habits during Covid, our new Labor government won’t be a big change on the economic front, says Pendal’s Anna Hong.

“Australians will be largely unaffected, at least near term,” says Anna.

Labor will increase fiscal spending by net $7.4 billion in areas such as home equity schemes and electric car discounts.

“That will prop up demand without fixing supply issues, nudging inflation higher and making the RBA work harder to counter loose fiscal policy.” The budget will remain in deficit for the rest of the decade.

Labor may face difficulty generating planned revenue and savings. “Many items on their list such as multinational tax revenue are easy to promise but notoriously difficult to achieve. “Overall, it’s more of the same for the economy and budget. The difference will be in other changes many voters are focused on – climate policy, federal integrity and gender equity.“