Fixed-Rate Bonds Crater

By Portfolio Manager Christopher Joye

Australia’s main fixed-income index—against which almost all superannuation funds benchmark—delivered its fourth worst return in modern history over the 12 months to 30 June 2017. In particular, the exclusively “fixed-rate” (rather than “floating-rate”) AusBond Composite Index returned just 0.25 per cent over the last year before you deduct fees.

After accounting for Australia’s 2.1 per cent inflation rate, investors in these fixed-rate bonds actually suffered a “real” return loss of minus 1.85 per cent from what is supposed to be a bullet-proof asset-class dominated by super-safe bonds.

Indeed, the AusBond Treasury Index, which is made up of twenty-plus AAA rated Australian government bonds, suffered an outright loss with a terrible return of minus 1 per cent over the year to 30 June (or minus 3.1 per cent after inflation).

As this column has long argued, the only safe-haven in fixed-income during this time of inevitably increasing interest rates is the vastly superior floating-rate benchmark, known as the AusBond FRN Credit Index, which furnished a handsome 3.5 per cent return over the year to June.

If you want to take a passive or so-called “beta” exposure to bonds, you can only achieve this through a floating-rate as opposed to fixed-rate index. I should make clear that this is a radical view—most institutional investors naively assume exactly the opposite. But they are categorically wrong.

When you put money into an at-call deposit account that moves up and down with the Reserve Bank of Australia’s cash rate, you intuitively understand something institutions don’t  get: you are not taking a punt on rates. You returns simply track the cash rate plus or minus the deposit’s margin.

If you think you are a genius and can accurately divine the RBA’s inherently non-forecastable long-term decision-making process, you can gamble on the future direction of rates by punting your money in, say, a 5 year term deposit. If rates fall over this period, you win. If they rise, you will have locked in your money at an inferior return and lost out.

The inverse logic applies to home loans: whereas a variable-rate mortgage takes a passive position on rates, fixing your repayments for 5 years is a massive “active” bet on what the RBA may or may not do.

Anyone familiar with the dismal performance of global macro hedge funds like Brevan Howard, which have armies of analysts and traders that specialise in trying to (unsuccessfully) predict long-run rate changes, knows that fixing your interest rate for elongated 5 year horizons is pure, unadulterated gambling.

You would do no better than closing your eyes and pegging a dart at a target with a randomly distributed range of interest rate outcomes.

So why is this important?

Because all your super savings are typically tied to the fixed-rate Composite Bond Index, which has an average interest rate duration of 5 years. That means these bond portfolios actually represent a combination of two entirely independent risks. The first is the super-safe underlying exposures comprising highly-rated government and corporate bonds, which provide an extremely high probability of being repaid the principal that you lent to these entities by investing in their securities.

The second factor is a gargantuan bet on where interest rates will be over the next half decade because you have fixed rather than floated your repayments.

Remember, investing in bonds and debt securities is all about moving up the capital structure and increasing the likelihood that you are repaid your principal and associated interest in comparison to (perpetual) equities that have no such certainty.

The macro interest rate bet in the Composite Bond Index explains why its annual volatility of 3.4 per cent since 2000 has been 6 times higher than the 0.6 per cent volatility of the FRN Index, which ironically has a slightly lower average credit rating.

In this context, retail punters are being treated by the launch of not one, but two different floating-rate Exchange Traded Funds that will offer them access to these securities for the first time.

Of course there will be those who argue that you can ignore all this risk and just focus on the fact that you will always be repaid your capital at the end of the day. That works for investors who do not care about the change in the value of their assets over time, which I would venture are practically few and far between.

It patently does not work for those who are buying bonds for their presumed liquidity, and want the freedom to liquidate their fixed-income portfolio to capitalise on higher risk opportunities as and when they arise.

If you value this liquidity optionality, and therefore care about the mark-to-market price of your assets, then I reiterate that the only truly passive bond portfolio is one that takes no interest rate risk through floating-rate exposures.

Needless to say, the RBA is doing its best to once again irresponsibly inflate the hazards to which prudent investors are subject. It is quite staggering that with a 5.5 per cent jobless rate, which is a sliver above full-employment, and headline inflation within the RBA’s target band, that the central bank nonetheless deems it appropriate to impose a negative real cash rate on savers. Punish the prudent while bailing-out borrowers, eh?

Other more sensible central banks around the world understand that if you keep rates too-low-for-too-long you inevitably blow asset price bubbles, an observation that has been completely lost on a myopic and immensely arrogant Martin Place, which is preternaturally incapable of admitting it is wrong.

Oh no, the rate cuts in 2016 had nothing to do with the “surprising” and striking re-acceleration in national house price growth back to double-digit rates in the months that followed. No, that was all about housing supply. Seriously Phil, bite the bullet brother.

You and I both know that we need to start on the road back to normality, and that one “financial stability” hike this year is not going to change the price of eggs in China. Since I have said that, though, I have almost certainly reduced the probability of it happening.

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