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Is the boom back for bonds?

Anthony Fensom  |  18 Apr 2019Text size  Decrease  Increase  |  
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Rumours of the bond bull market’s death have been greatly exaggerated. From worries over a global monetary tightening cycle driven by the US Federal Reserve, suddenly rate cuts are on the horizon for global policymakers and the fixed income market is reaping the rewards.

“The market has adjusted its view, and so has the Reserve Bank of Australia (RBA) judging by its latest statements,” says John Likos, Morningstar’s director of equity & credit research, Australia & New Zealand.

“There’s increasing expectations of rate cuts – we think there will be one this year – supported by weak inflation and a weakening in employment data.”

The latest futures pricing points to a 76 per cent chance of an RBA rate cut as early as August, with a decrease by October considered a virtual certainty.

This follows the release of the central bank's April monetary policy meeting minutes, which highlighted slower domestic economic growth, weak housing conditions and low inflation.

In the bond market, 10-year government bond yields have declined to “historic lows”, including in Australia, the RBA said, with negative yields in Germany and Japan. In the US, the next move in the benchmark federal funds rate is now “expected to be down”.

After US bond yields peaked last November, the first quarter of 2019 has seen “outsize gains” in fixed income markets thanks to declining interest rates and tightening credit spreads, according to Morningstar.

Amid slowing US economic growth, a weak global backdrop and deteriorating financial conditions, Capital Economics argues the Fed could start cutting rates as soon as “the fourth quarter of this year, although we wouldn’t rule out an earlier move”.

For bond investors, the good times appear to have returned.

However, Likos cautions that not all bonds are created equal.

Evidencing this was the recent collapse of Australian fintech Axsesstoday (ASX: AXL), which entered into voluntary administration on 7 April less than a year after issuing a $50 million bond to retail investors. Not one interest payment was made.

“This highlights the fact that in a risk-off environment, not all corporate bonds are equal, so lower- to medium-risk investors need to stay in the higher-quality spectrum,” Likos says.

On the positive side, household names McDonald’s and General Motors both issued their first Australian dollar corporate bonds in late February, with such “kangaroo bonds” enjoying strong support from local asset managers.

Hybrid volatility

In the hybrid market, Morningstar’s March 2019 credit monthly report noted the local market’s “strong run over March, notwithstanding the increase in supply”.

However, Likos pointed to increased volatility in the hybrid market ahead of the 18 May Australian general election.

“The overriding concern in the hybrid market is whether Labor’s franking policy will be approved in its proposed form. I think it will be watered down in the Senate, but if it does go through as proposed then you could see a hybrid sell-off,” Likos warns.

“Hybrids will survive, as they have an important role to play in the banks’ capital structure. However, while new buyers should come in, it might be at margins 20, 30 or 40 basis points higher than where they are now.”

Lower for longer?

Weakening global economic growth and geopolitical worries point to rates staying lower for longer, Likos says, with the bullishness of late 2018 quickly evaporating.

“There was a point when the US 10-year bond yield got to 3.2 per cent…we thought technical barriers had been broken and the next stop was 4 per cent, but then it reversed course sharply as investors were reminded of geopolitical concerns and global economic weakness,” he says.

“A lot of stimulus initiatives have not had as strong an effect as expected, including the US tax cuts. So the good times never went away [for bonds] and if they did, it wasn’t for very long”.

Looking ahead, Likos sees the “search for yield” remaining strong, with the prospect of bond prices going higher still despite being “extremely expensive on an historical basis”.

“The other issue is the proportion of negatively yielding bonds globally, which is not painting a very positive picture of near-term economic expectations”.

The world’s stock of negative-yielding debt now exceeds US$10 trillion, albeit below its record-high US$12.2 trillion reached in June 2016. This is about 20 per cent of global investment grade bonds.

For Australian investors, Likos says a likely downward trend in interest rates points to being cautious towards floating rate instruments, which are likely to follow the cash rate lower, while hybrids face volatility pending the election outcome.

“Stick to quality and stay diversified. You don’t want to be stuck in a more risky exposure, such as a non-investment grade or unrated issue, if the default cycle beings to turn and you can’t get your money out,” he says.

is a Morningstar contributor.

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