The Point

Fast podcast: Why bonds look compelling towards mid-2023

There are signs that inflation has peaked and is due to come off in the next few quarters, says Oliver Ge, an assistant portfolio manager with our income and fixed interest team.

“That would invariably take us to a position, maybe in Q2 2023, where it looks quite compelling to own bonds,” says Oliver in our latest fast podcast.

“At that point you’d already see inflation pressures come off and growth indicators start to materially deteriorate.

“Then central banks will in all likelihood tilt their reaction function to be more benign, more dovish.

“They’re not accelerating, there likely won’t be more hikes. That environment is conducive to owning bonds.

“You’re looking at returns of five to six per cent per annum at that point.”

Fast podcast: What the Budget, inflation and rates mean for bonds

What do this week’s Budget and inflation numbers — and next week’s likely 25-point rate rise — mean for 2023? And the role of bonds in portfolios?

“The key takeaway I have from the last couple of days is this inflation issue is not going to solve itself quickly enough to call an end to rate hikes anytime soon,” says Pendal’s head of government bond strategies Tim Hext in a new fast podcast.

“We are getting the ingredients — particularly globally more so than Australia — where in the second half of next year you could be getting a lot of weakness globally feeding through to the need for lower rates.

“My message — and this has been a consistent message for a number of months now — is start to think about getting some bonds in your portfolio as a defensive instrument.

“I don’t think they’re necessarily going to rally hard in the near term. But if you can own those 10-year bonds in Australia at 4% on a two or three-year outlook, I think you’re going to do well out of them.

“And they’re going to give you that buffer should the slow-down prove to be stronger.”

Amy Xie Patrick: Why it’s a myth that you shouldn’t buy bonds in a hiking cycle

Bonds can be an appropriate investment in a hiking cycle – as long as you know what to look for, argues Pendal’s head of income strategies Amy Xie Patrick.

“It’s a common misconception that you shouldn’t buy bonds in a hiking cycle,” says Amy.

“In a lot of hiking cycles, bonds actually do okay on a total return basis – that is, the income you get from the coupon on those bonds, as well as their potential to gain a little in terms of the capital price.

“That’s usually because most hiking cycles are fairly well flagged. The difference with this hiking cycle is the central banks left it too late and now have to catch up.

“Even though central banks may need to keep hiking, now their mantra is well flagged so there’s hope bonds can do better in the second half of the cycle.

“It does mean you probably want to look at having bonds in your portfolio as a defensive pillar, more towards the longer end of curves.”

FAST PODCAST: Where inflation is heading and how to think about bonds now

How should investors be thinking about bonds now?

The market is factoring in 3% cash rates and believes we’ll get there around Christmas, says Pendal’s Tim Hext in this podcast.

“I think they’re probably going to end up closer to 2% than 3%, but the point is the market pricing.

“If you buy a bond today, you’re buying the expected interest rates in the future, which are quite high. A 10-year bond is now 3.5%.

“Last time we spoke on this podcast we were heading through 2.5%. I said then, if you’re underweight bonds, you might want to start thinking about getting back to neutral.

“Now they’re starting to get into territory where you could even look at going overweight bonds.

“I believe inflation eventually heads back 2.5% to 3%. And real interest rates – the return you get above inflation – shouldn’t move a lot higher than where they are now, around about 1% for 10 years.

“If you give the government your money today, you’re in a sense locking in an inflation rate around 2.5%, plus an extra 1% return on top, which in my mind for a risk-free asset is quite a good return.”

FAST PODCAST: How the China slowdown is affecting Aussie investors

What does China’s slow-down mean for the global economy – and specifically for fixed income investing?

“We’ve been sheltered so far because our comeback from Covid – thanks to a lot of fiscal stimulus around the world – has helped buffer these headwinds coming out of China,” says Pendal’s Amy Xie Patrick in this week’s fast podcast.

“But at least in the short term China’s lockdown measures are leading once again to bottlenecks in supply chains and logistics.

“Slowing growth should mean bonds have their heyday again. But in the near term it’s difficult to say this is the turning point in bond yields, because inflation is still a worry.

“If the growth situation in China gets materially worse – which isn’t our base case – fixed income portfolios that look a lot like equity portfolios with a lot of credit and high yield in them will fare poorly.

“But if you are willing to dip your toe into purer fixed income portfolios that rely much more heavily on that duration lever – those portfolios will be more reliable at delivering a defensive performance profile if the worst scenario eventuates out of China.”

FAST PODCAST: Not all income funds are well positioned for rising bond yields

Bond yields have been rising and fixed income investing is gaining advocates.

But not all income funds are in the right position to take advantage says Pendal’s head of income strategies Amy Xie Patrick.

“One year ago, to invest in risk-free bonds in Australia, you were getting paid virtually nothing,” says Amy in her latest podcast. “Now you’re getting paid nearly 2.5%.

“But if you don’t have the flexibility within your portfolios to take advantage of this higher-yield environment, then this is a really large prize you are being forced to forego.

“Investors need to look at what kind of income fund they’re getting into. Is it a buy-and-hold, steady as she goes, let’s-not-do-much-about-it kind of income fund?

“Or has your income fund actually been incredibly active to insulate you against the rising interest rate risks, the rising macro risks, that have occurred over the last 6-to-12 months?

“The latter is positioned with more flexibility – and more dry powder – to take advantage of the higher yields we have today.”