Beware the bond market trap

Co-founder of the Switzer Report
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Last week’s Reserve Bank of Australia (RBA) Board Minutes gave further heart to those expecting another cut in interest rates. Central banks don’t get much more explicit than: “Members considered that further easing may be appropriate in the period ahead.” My bet is that they will cut again in December to try to take some pressure off the Australian dollar and give the domestic economy some pre-Christmas cheer – notwithstanding ongoing signs of a pick-up in the United States and optimism about China.

However, at some stage, the interest rate cycle is going to turn around and the great bull market in bond prices will end. As the 10-year Australian Government bond yield chart shows, it has been pretty much a one-way bet over the last decade on lower bond yields (remember, when yields are low, bond prices are higher), apart from a blip in the early part of 2009.

I am not ready to call this great bull market over yet – however, I see very little value, from a risk/return perspective, in investing in long-term bonds or fixed-interest securities at these levels.

Risk? Yes, and let me explain, as there is some quite misguided commentary floating around that suggests that investing in fixed interest is riskless – it is not!

Fixed interest and risk

There are two risks you need to be mindful of when investing in fixed-interest securities such as bonds: ‘credit risk’ and ‘interest rate risk’. For this discussion, let’s put ‘credit risk’ to the side. Credit risk is the risk that the borrower goes broke and can’t repay. The credit risk on government, semi-government or bank bonds is relatively low. Be mindful though that if you purchase bonds or fixed-interest securities issued by lower quality borrowers (ie. weaker credits), the credit risk increases and becomes the most material risk.

Let’s focus on ‘interest rate risk’, which is sometimes called duration risk. This is the risk that the market value of your bond changes due to a change in market interest rates. Like shares, bonds or fixed-interest securities have a market value and this value changes (arguably) daily. For a self-managed super fund (SMSF) that is required to value its assets at ‘market value’, this means that, like shares, ‘paper’ gains or losses on fixed-interest securities will occur, impacting the value of each members’ account balance.

Of course, if you hold the bond or fixed-interest security until maturity, then you will get back the face value of the security.

How big is the risk?

Bigger than many people think. The table below shows the impact in price for a one and two percentage-point increase in interest rates on each of a three, five and 10-year bond.

So, if interest rates on 10-year government bonds increase by two percentage points, holders of 10-year bonds face a market (paper) loss of 15.5% – that’s equivalent to investing in the stock market and seeing it fall from 4,400 to 3,718.

Could it happen?

As the chart above shows, 10-year government bond interest rates moved up by around 1.75% in the first half of 2009. For those with longer memories, such as old bond traders like myself, the great bond ‘crash’ of 1994 when 10-year bond rates rose from 6% to over 10% in the space of three months is living proof. A ‘crash’? Very much so. If you use the October 1987 sharemarket ‘crash’ as the benchmark, you will find that the market value of 10-year bonds in percentage terms declined by almost as much as did the sharemarket on that fateful day.

Alarmist – yes (and I apologise). The chance of a repeat is relatively unlikely. And while the interest-rate risk on a bond can translate into significant price risk, it is still less than the price risk on a share or a portfolio of shares. Shares are more volatile than bonds – it is just that bonds aren’t as riskless as often believed.

The bottom line

I am a great believer in a well diversified portfolio, which includes an allocation to fixed-interest securities and bonds. Bonds as an asset class tend to be inversely correlated to equities (which means that they move in the opposite price direction), providing important protection to a portfolio and facilitating a higher overall portfolio return for a lower level of risk.

However, with the yield on 10-year government bonds at multi decade lows, I can’t get excited. I feel caution is the order of the day.

How should you play this market? Either reduce your allocation to fixed interest, or alternatively, reduce the duration (effectively, the term) of your fixed interest portfolio by moving out of longer-term bonds and replacing with shorter-term bonds or floating-rate securities. If you invest through a bond fund, consider switching into a fund that benchmarks against the ‘Zero to three-year index’ rather than the ‘all bond’ index.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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