Investing in government bonds or in bond funds is meant to be a “defensive” play. That is, you get a nice secure income without much risk of capital loss. After all, the biggest issuer of bonds is the Australian Government – and lending to it should be “as safe as houses”.
Bonds are also historically categorised as “negatively correlated assets”. This means that when added to a portfolio that contains riskier assets such as shares or property, bond prices go the opposite way. So when the share market tanks and prices fall, bond prices should rise which then provides an offset for the portfolio. The theory says that in the right combination and relative to risk, shares and bonds can deliver the optimal return.
So imagine the surprise many investors are getting when they examine the returns on their bond investments last financial year. Bonds and bond funds have bombed – losing on average between 8% and 16%. Moreover, they have fallen in price at the same time as share prices have fallen.
Not much of a “defensive asset”!
The market-leading iShares Core Composite Bond ETF (IAF) is a case in point. A benchmark ETF (exchange traded fund) that tracks the entire “investment grade” Australian bond market, it comprises 539 bonds issued by the Australian Government, State and Territory Governments, banks, major corporations and supranationals. In 21/22, it delivered a net return of -10.68% (income return of about +2%, capital return -13%). Starting at $113.32 per unit, IAF finished the financial year on the ASX at $99.60.
Over 3 years, IAF’s total return is also negative at -2.75% pa. Out to 5 years, it gets marginally positive, but only a paltry 0.69% pa.
Funds that invest in corporate bonds (as opposed to mainly the government bonds that IAF holds) have done even worse because when interest rates rise, spreads tend to widen (that is relative to the adjacent government bond, corporate bonds trade at a higher margin).
In addition to the index funds run by iShares or Vanguard, there are a plethora of actively managed bond funds. Some will have done better than IAF, others a lot worse, but virtually none will boast a positive return for 21/22.
The latest data from the RBA puts the size of the Australian bond market at almost 2 trillion dollars – $850bn in Australian Government Bonds, $400bn in State Government Bonds and $600bn in non-government bonds. Assuming on average a decline of 10% in value, this means investors – retail investors, institutional investors such as the big super funds, the banks and the RBA – have collectively lost about $200bn on bonds in 21/22. Yes, paper losses of $200bn!
They are “paper losses” because the losses are calculated on a “mark to market” basis and are not realized until the bonds are sold or mature. With interest rates going up, newly issued bonds pay a higher interest rate than older bonds. To make investors indifferent as to whether they buy an ‘old’ bond or a ‘new’ bond, the price of the old bond falls to the point where an equilibrium is reached such that the investor’s additional return from buying the old bond at a discount to face value, plus the interest on the ‘old’ bond, is equal to the interest on the ‘new’ bond.
Why have interest rates gone up and bond prices fallen? Inflation and the Reserve Bank.
Inflation is the factor that bond markets fear the most because investors in long-term bonds that mature in 10 or 20 years require a return that will keep pace with inflation. They don’t want to see the real value of their investments decline. So if inflation increases, long-term interest rates rise and vice-versa when inflation falls.
Driving inflation has been supply chain disruptions coming out of the pandemic and labour mobility issues, the Ukraine war and surge in energy and food prices, and in Australia, the impact of the floods. Inflation is a global problem which means that we also “import” inflation.
The Reserve Bank’s role in sending interest rates skywards follows the withdrawal of its stimulus programme. Known as ‘quantitative easing’ (effectively “printing money”), the Bank had been standing in the market and buying Australian Government Bonds of a term of up to 3 years at a yield (interest rate) of just 0.10% pa. In February, the RBA announced the cessation of further bond purchases and interest rates soared. Today, the yield (interest rate) on a 3-year Government Bond is about 3.0%.
But there could be a silver lining for bond investors. In the medium term, income returns from bond funds will increase because as they buy new bonds or re-invest the proceeds from the maturity of older bonds, they will invest at a higher interest rate and be able to increase the size of their distributions. Also, if interest rates are nearing the peak and start to move back down, the “mark to market” prices for bonds (and bond funds) will increase.
One thing is for sure. The last financial year will go down as one of the worst ever for bond funds. The odds are against a repeat performance in 22/23.
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.
