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Declining interest rates put blowtorch on Aussie bond yields

Glenn Freeman  |  07 Jul 2016Text size  Decrease  Increase  |  

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With Australian markets anticipating a further drop in official interest rates, bond investors will find it increasingly difficult to maintain current returns, according to Henderson Global Investors' head of Australian fixed interest, Glenn Feben.

"The consensus view, and we agree, is that will be the case. There is a market expectation that the cash rate is going down, it's reflected in the way the market is priced today," Feben says.

"It would only be a surprisingly high inflation number that would stop them from easing policy further."

He points to forecasts that tip the cash rate to fall to 1.5 per cent by October 2016.

"For August, which is when the next [Reserve Bank of Australia] meeting will be, it's trading at 1.6 per cent ... from the current rate of 1.75 per cent. The market is assigning a greater than 50 per cent likelihood that the cash rate will go down again."

Keeping inflation between 2 per cent and 3 per cent is a core mandate of the RBA. Its decision to ease interest rates in May 2016 was prompted by a lower-than-expected inflation number, "and we now have inflation that is way below the RBA target," Feben says.

A global challenge

"Everyone is challenged by the interest-rate environment we find ourselves in. Across the globe, we've never seen long-term bond yields at these sorts of levels," says Feben.

He believes this near-universal decline in bond yields, which are currently at 10-year lows, are flowing onto the Australian market--even though our yields are attractive in relative terms.

"In Australia, we're being dragged down partly because of what's occurring on the local macroeconomic front--which is being reflected in an increased cost of Australian cash, rates going down ... and a decline in the overall term structure of yields," Feben says.

"And on top of that you've got these global forces ... effectively underpinning declines in European yields, and making markets like Australia look relatively attractive."

He emphasises that this attractiveness is only relative to many other developed economies.

"Australian yields, by any historical assessment, look relatively low," he says.

"To me it's like a game of musical chairs. I don't think any longer-term value-driven investors, unless you believe you're headed into a long-term global deflationary environment, thinks rates at these levels are, in an absolute sense, attractive.

"1.8 per cent is about all you'll get on a 10-year bond yield ... with the cash rate at 1.75 per cent and the bond rate at 1.8 ... there's not much additional yield to be had, so of course the cash rate is likely to go down further," he says.

The new normal?

"In a normal, classic business interest rates cycle, you'd expect some degree of steepness [in the yield curve] ... and yet, we look at it today and it's an extremely flat yield curve," Feben says.

From an individual investor perspective, he says Australian fixed-income returns have held up in the first half of 2016, on the back of obviously declining yields.

"So the price change in the value of bonds is boosting fixed-income returns. That's fine, but eventually you reach a point where that will have to stop, and you're faced with what is now lower and lower yields," he says.

"Post-GFC, as their budget positions have deteriorated, governments have been borrowing to fund their deficits. So there has been a very significant increase in government issuance [of bonds]."

In turn, this has led to an increase in the average term, with the Australian government issuing a greater number of longer duration bonds.

"So at a time when you've got the highest level of duration ... you've got the lowest level of yields," he says.

Modified duration

In the context of fixed income, the term "modified duration" refers to the sensitivity of a bond to a change in yields. The longer the term of the bond, the more sensitive it is when yields move.

"When yields are falling, holding long-term bonds is great. And on the other side, when it goes the other way, it's not so great," says Feben.

"So that says if we get into a rising rate environment in future, you've got very little income to protect you from that impact."

He explains that the duration of bonds is their key defensive attribute.

"But I do think about this: To what extent are the defensive attributes for fixed income being eroded because we do have yields at such low levels? Their capacity to keep going down has to diminish," Feben says.

"To some degree, you've got to say 'there's got to be an end to this'. And when it does end, you probably, by choice, wouldn't want to be in long-duration fixed-income funds.

"But people have been calling the end of the bull bond market for some time, and yet it keeps going on."

More from Morningstar

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• It's not me, it's EU


Glenn Freeman is Morningstar's senior editor.

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