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The Point
Quick, actionable insights for investors
Income and Fixed Interest
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?
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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.
Anna Hong: What we learned from the latest RBA minutes
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Anna Hong: What we learned from the latest RBA minutes
Anna Hong: What today’s RBA rate hike means for investors
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Anna Hong: What today’s RBA rate hike means for investors
TIM HEXT: What investors should know about the outlook for State debt
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TIM HEXT: What investors should know about the outlook for State debt
TIM HEXT: Inflation noise gets louder but real yields move markets
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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
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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.“
TIM HEXT: This week’s modest wages data won’t last
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TIM HEXT: This week’s modest wages data won’t last
The latest wage data shows surprisingly modest growth in some sectors.
But wages are the ultimate lagging indicator and that will soon change, says Pendal’s Tim Hext.
The latest WPI data shows the price of labour grew a modest 0.7% in the March quarter and 2.4% for the year.
Those numbers may be surprising especially in industries such as construction and retail which face worker shortages.
But the data will change, since we’ve only fully opened up this year, says Tim.
“The RBA expect the WPI to hit 3% by year end and 3.5% by the end of 2023. Chances are we hit these levels sooner.
“This adds to the narrative that inflation will struggle to fall back to target anytime in the next few years. Investors should still be looking to inflation bonds ahead of nominal bonds.
“Inflation will moderate next year but levels above 3% look like being more entrenched over the next two to three years, helped by wages eventually nearing 4% growth”.
Tim Hext: RBA in final preparation for take off
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Tim Hext: RBA in final preparation for take off
The RBA’s “loss of patience” was widely noted this week.
Investors will now be watching Q1 CPI data on April 27 (“likely around 1.7% and 1.2% underlying”, says Pendal’s Tim Hext) and Q1 Wages Price Index on May 18 (“less spectacular but won’t stop a June tightening”).
There’s also a good chance one of the next unemployment numbers will be below 4%, says Tim.
“The RBA will therefore be able to say in May that inflation is sustainably within its band in the medium term and can tighten in June.” (A May hike ahead of an election is less likely.)
“The short end of the bond market is now predicting cash rates to peak around 3.5% in early 2024. If mortgage holders were aware of this impending doom house prices would be off 10% tomorrow.
“Mortgage brokers I’ve spoken to are telling clients rates shouldn’t go up by more than 1% to 1.5%. The average size of a new mortgage is now well over $600,000 – so an extra $20,000 a year in interest is coming borrowers’ way if markets are correct.”
Tim expects rates to finish 2022 around 1.25% and 2023 around 2.5%.
Federal Budget will embolden the RBA on rates — but not as much as you think
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Federal Budget will embolden the RBA on rates — but not as much as you think
Not surprisingly in an election year, the federal government is already spending its recent windfall in this week’s Budget.
How will this affect rates?
In recent months the Budget improved by about $115 billion (over four years) as Australia’s terms of trade boomed and massive fiscal spending delivered a stronger economy, says Pendal’s Tim Hext.
Josh Frydenberg has already spent $30 billion of that on top of $16 billion in earlier pre-election handouts.
“This adds further fuel to an already strong economy,” says Tim.
The Budget will further encourage the RBA to admit they need higher rates. “But with markets forecasting 2% rates here early next year — and 3% by the end of next year — there is simply too much priced in.
“We think the US will get to those levels, but investors assuming Australia must follow are missing a couple of factors.
“Firstly, our inflation is significantly lower. Secondly, our floating rate mortgage market means any rate hikes have more impact sooner.
“It may seem strange but when the RBA actually starts to moderately tighten rates, bond markets will likely rally.”
The future of bonds (no they’re not disappearing)
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The future of bonds (no they’re not disappearing)
Technology is changing our lives all the time. In financial markets it’s no different.
“The next decade will see an increased use of blockchain technology across all asset classes and finance,” says Pendal’s head of government bond strategies Tim Hext.
“This will increase efficiency. But it won’t make the underlying assets redundant.
“Crypto will have a role but it will not replace the Australian dollar. Bonds may become more digital but they will not disappear.
“The need to borrow and lend money is as old as time itself — and the need for efficiency in buying and selling loans packaged as bonds will also remain.
“Diversification remains an important investment concept. Add liquidity and credit quality and it means government bonds are not going anywhere.”
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