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Bond market bounces back

Anthony Fensom  |  15 May 2017Text size  Decrease  Increase  |  

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While an imminent surge in yields appears unlikely, there are still attractive opportunities for fixed-income investors in the current environment.


President Trump, rising US interest rates, and geopolitical instability were all supposed to spell the end of the 35-year bond bull market. Yet 2017 has been far from a disaster for fixed-income investors, as noted by Morningstar's senior credit analyst John Likos.

A surge in bond yields in late 2016 on expectations of "Trumponomics" saw the yield on benchmark 10-year US Treasury notes hit a record high of 2.6 per cent in December, double their level after Britain's "Brexit" shock in July.

In Australia, the yield on the 10-year Commonwealth bond hit 2.9 per cent in March this year, its highest level since 2015, amid expectations of a rate hike by the Reserve Bank of Australia (RBA) later this year and a potentially faster-than-expected pace of US rate increases.

Yet bond yields in Australia, the United States, and other major developed economies have since eased back amid the US Federal Reserve's slow pace of rate rises, diminishing expectations for massive US fiscal stimulus and weaker oil prices.

During April, US 10-year government bond yields slipped back to 2.3 per cent, while yields also fell in the Eurozone and Japan. In Australia, the benchmark yield slipped to 2.57 per cent, even while the market indicator, ASX interbank cash rate futures, continued to predict an RBA rate hike in 2017.

Nevertheless, the RBA kept its official cash rate steady for the eighth straight month in May, staying at a record low 1.5 per cent amid low inflation and sluggish wages growth.

"The thesis behind the bond bull market being over isn't playing out as some people thought--there's still a lot of uncertainty regarding President Trump's agenda," Likos said.

"There are a lot of factors clouding each other, with the Fed on one hand and Trump's agenda on the other, and then there's geopolitical risks like North Korea.

"Bond markets haven't reacted anywhere near as aggressively as they did when Trump was elected."

Likos said the Fed would still increase rates "a couple more times this year," but the RBA likely would remain on hold amid mixed indicators on the housing market and employment.

"For Australian fixed-income investors, it's still an attractive asset class as the base rate is likely to stay very low and the whole search for yield theme is far from over," he added.

Bonds to watch

Likos suggested it was "harder to identify compelling value among hybrid securities," which comprise elements of both debt and equity securities.

However, he said particular securities, such as National Australia Bank (ASX: NAB) issue NABPB, remained attractive due to a "shorter term to call".

On 12 May, NABPB had a "yield to reset" of 5.17 per cent including franking credits, with a distribution of 91 cents.

"Senior major bank debt looks pretty good relative to the capital structure--we have a lot of confidence in the financial and business risk profiles for wide-economic-moat-rated banks like NAB," he said.

Likos expects "a lot of supply to come out of the retail hybrid market" in 2017 as issuers seek more attractive funding options elsewhere, such as in the wholesale markets.

"We've seen Australian and New Zealand Banking Group (ASX: ANZ), Origin Energy (ASX: ORG), Woolworths (ASX: WOW), and others buying back their hybrids without replacing them ... there are a lot of issues not being rolled over as they seek cheaper funding elsewhere," he said.

Yield spike?

BetaShares chief economist David Bassanese attributes sluggish growth in long-term bond yields to "market confidence that central banks will retain extraordinary monetary stimulus, even in the face of what are now near full-employment conditions" in the major advanced economies.

"What's remarkable is that this policy timidity comes at a time when unemployment rates in both the United States, Japan, and parts of Europe have fallen to pre-financial crisis levels," he commented in a 10 May report.

Morningstar's Likos suggested improving economic conditions in Europe and a more expansionary fiscal stimulus in the United States could have the potential to send bond yields higher, while inflation and unemployment remained the key indicators in Australia.

Yet with France recently electing a centrist president, Trump finding Congress more challenging than expected when pushing through his spending agenda, and consumer prices staying low in Australia, an imminent surge in yields appears unlikely.

"We still have a reasonable environment for investing. While not as bullish in the past, there are still attractive opportunities for fixed-income investors," Likos said.

"The critical component of fixed-income investing is preservation of capital, and maintenance of spending power through obtaining a real rate of return, and in my view, fixed income will continue to provide that."

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Anthony Fensom is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria. The author does not have an interest in the securities disclosed in this report.

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