Bonds have been strong performers over more than a decade in the lead-up to the current crisis, and we believe they could play an important part in defensively-positioned portfolios in future. While there is a certain lack of understanding about bonds on the part of many investors, relative to equities, but the principles are quite simple. Here are a few things we bear in mind when considering a role for bonds in a portfolio:
1. Income and defensive positioning
An important part of building a defensive position into a portfolio is the inclusion of securities with cash flows that are resistant to market downturns. Considering the credit risk of the issuer, bonds can offer an opportunity to harvest regular and reliable income streams with lower risk of capital instability.
2. Returns are typically driven by interest rate sensitivity
As interest rates fall, the discount factor used to value income streams is reduced, increasing the value of those cash streams today. The yield on issued bonds becomes more attractive, driving up prices and returns.
The sensitivity of a fixed income security’s price to changes in yield increases the further a bond is from its maturity. When measuring how sensitive a bond’s price is to changes in interest rates, we refer to its duration (as explained below).
The strong performance of bond markets over the past decade has been driven by a falling interest rate environment, fuelled by a series of financial crises and the lack of ability on the part of most major economies to generate significant inflation, in turn necessitating monetary stimulus in the form of lower interest rates. In this environment, portfolios with higher duration have tended to perform strongest.
The gains on offer from interest rate risk have plateaued in recent years as interest rates across most of the developed world have effectively bottomed out, and it’s important for investors holding these assets to understand the specific role they play in their portfolio structure.
3. Investment-grade credit can play a defensive income role
Credit spreads are the difference between yields on non-government bonds such as corporate bonds and government bonds, and represent the additional credit risk premium allocated to the issuer of the bond. Credit spreads widened dramatically during the first stages of COVID-19, as passive bond funds underwent forced selling and introduced excess liquidity into the market. Over the past few months, however, spreads have largely stabilised towards pre-COVID levels, particularly in investment-grade bonds.
Despite this, investment-grade credit spreads tend to have a fairly low volatility, and well-constructed portfolios may provide access to this credit risk premium for a low level of downside risk. We find that through the cycle, investors in Australian investment-grade bonds tend to be overcompensated for the credit risk they are taking. By investing into a diversified portfolio of stable investment-grade bond issuers, investors may earn superior risk-adjusted returns, and do so without seeing undue volatility in the total returns they earn from these investments. In an environment of very low yields globally and where investors are being tempted down the quality spectrum to earn moderate returns, we view this as a key means of earning defensively oriented income in an uncertain environment.
4. The outlook for Australian investment-grade bonds remains positive
Australian companies were better prepared for this crisis than their counterparts in countries such as the US. We believe Australian corporates entered the recession with stronger and more conservatively positioned balance sheets and were quick to raise equity where they faced uncertainty. This supportive attitude has been reflected in ratings, and our corporate sector has for the most part avoided the ballooning leverage witnessed in other markets.
That said, there are still considerable downside risks ahead relating to the future evolution of the pandemic and the capacity for our economy to recover. Uncertainty is likely to persist for some time, especially with the risk of further waves and lockdown.
Despite this potential volatility, inflation and interest rates are likely to remain low in the short to medium term, and future stimulus programs should remain highly supportive of credit markets. We view a well-constructed portfolio of defensive income in this space as being a critical component for weathering this uncertain economic environment.
Decoding the corporate bond discussion
The key to understanding bonds is becoming fluent in the terminology used to describe the various attributes of fixed income securities. Let’s take a run through a few of the more important concepts.
Types of yield
Current yield, also known as running yield, refers to the annual payout as a percentage of the current market price. For example, the current yield on a bond with a market price of $1,000 that pays $80 per year in interest is 8%. Running yield is a similar concept to the dividend yield for equities.
Yield to maturity, or gross redemption yield, is a yield that represents the total coupon payments for that bond if held to maturity, plus interest on interest (the reinvestment), and the gain or loss realised from the security at maturity.
A yield curve is a function that traces relative yields on a type of security against a spectrum of maturities ranging from three months to 30 years or longer.
The next consideration is the way that yield responds to interest rate movements and credit risk.
Interest rate sensitivity
We use the term duration to broadly refer to the extent to which a bond’s pricing responds to interest rate movements. Technically, it’s a weighted measure of the amount of time until the cashflows of the bond are received (Macaulay duration). As such, it reflects the timing and magnitude of each cash flow, and the extent to which changes in the discount rate for those cash flows (at the prevailing interest rate) will affect the price of the bond.
Modified duration is an extension of the Macaulay duration concept, whereby it directly expresses the percentage change in the price of a bond for a given change in interest rates.
Credit sensitivity
Credit risk is the expected risk of loss due to the issuer delaying or defaulting on interest or principal payments. Credit risk is assessed by agencies who issue credit ratings on the quality of debt securities.
Bond issuers with lower credit ratings must pay a premium to investors who purchase their bonds. The difference between the yield on a bond and a government bond of the same maturity (effectively a risk-free rate of return) is known as the credit spread, measured in basis points.
Credit spreads are affected by factors such as the financial strength of the issuer, broader macroeconomic conditions and the demand and supply amongst investors for the issuer’s securities. After purchasing a corporate bond, the bondholder may benefit from a narrowing of the credit spread which all else being equal, should drive up the price of the bond, delivering a capital gain.
In a similar fashion to interest-rate sensitivity, the term credit spread duration is used to refer to the sensitivity of a bond’s price to movements in credit spread. Typically, the higher the credit spread duration in a portfolio, the greater the credit risk that investors are exposed to.
Understanding corporate bonds, or fixed income generally, does not need to be complicated. Once the basic principles are broken down, investors can better understand how corporate bonds may perform in a changing interest rate and macroeconomic environment.
Nathan Boon is Head of Credit Portfolio Management and Co-Portfolio Manager at AMP Capital, a sponsor of Firstlinks. This document has been prepared for the purpose of providing general information, without taking account of any investor’s individual objectives.
For more articles and papers from AMP Capital, click here.