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Bonds: Still a safe port in a storm?

Anthony Fensom  |  07 Apr 2020Text size  Decrease  Increase  |  
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Even government and corporate bonds with top credit ratings - the safest of fixed income assets - were caught up in March's rout of global financial markets as investors scrambled for cash.

The result was a dramatic spike in bond yields, hitting levels not seen since the global financial crisis, reflecting fears that highly indebted borrowers would not survive COVID-19.

“In a crisis, correlations go to one,” AMP Capital’s Shane Oliver told the Australian Financial Review, implying that the traditionally negative correlation between equities and bonds had disappeared.

The sell-off saw Australia’s benchmark 10-year government bond yield spike to 1.5 per cent from its low of 0.6 per cent just weeks earlier. Similarly, US 10-year Treasuries surged to 1.25 per cent after trading at 0.54 per cent earlier the same month.

Bid-ask spreads for fixed interest exchange-traded funds also widened to levels not seen since the GFC. In one example, the Vanguard Australian Corporate Fixed Interest Index Index ETF (ASX:VACF) saw its sell spread reach 1.79 per cent, up from 0.15 per cent previously.

Popular bond ETFs also saw their discounts to net asset value widen substantially, to as much as 10 per cent for funds such as the VanEck Vectors Australian Corporate Bond Plus ETF (ASX:PLUS).

In response, Macquarie Bank (ASX:MQG) joined National Australia Bank (ASX:NAB) in cancelling planned hybrid capital raisings, due to “significantly changed market conditions”.

Australian bond funds including those managed by AMP Capital, Macquarie, UBS and Vanguard, reacted by hiking exit fees to manage redemptions.

According to Morningstar, such exit fees have risen from less than 10 basis points (0.1 per cent) to as high as 90 basis points for core Australian fixed income funds. Corporate bond funds have followed suit, raising exit fees from between 10 and 55 basis points to as high as 200 basis points.

Fortunately for investors, central banks including the US Federal Reserve and the Reserve Bank of Australia (RBA) stepped in to boost liquidity, committing to buy billions of dollars of bonds and other financial instruments to calm markets.

In addition to its historic quantitative easing measures, the RBA cut the official cash rate to a new record low of 0.25 per cent, citing the need to support the economy through this “challenging” period.

As a result of QE, the three-year bond rate fell below the RBA’s 0.25 per cent target, while the benchmark 10-year rate dropped back below 0.7 per cent after soaring to 1.7 per cent.

Signs of life in the corporate bond market have also emerged, such as Transurban’s move to raise 600 million euro (A$1.08 billion) through the issue of a BBB+ rated Eurobond.

It was the first such move in months by an Australian company to access investment-grade bond markets overseas and could spark similar raisings by other blue chip companies.

However, with Australia set to issue up to $300 billion worth of government bonds over the next 15 months, competing with other governments doing likewise, questions have been raised over the nation’s coveted triple A credit rating.

Ratings agency Moody’s has downgraded the credit outlook for Australia’s banking system to “negative” from its previous “stable” outlook. This serves as a warning of the stresses imposed on banks due to the impact of an economic shutdown on profits and loan repayments.

Yet analysts suggest that a combination of RBA bond buying, demand from local banks and Australia’s relative fiscal strength should absorb the extra bond issuance. This should ensure bond prices remain relatively stable.

If the bond market boom has died, then its death has been greatly exaggerated.

“It's too early to say the bull market is broken because if central banks dramatically ramp up quantitative easing and we go into recession, then bond yields could easily go back down,” AMP’s Oliver said.

Capital Economics expects central bank support and low inflation to support safe haven assets such as bonds, with the Fed and other central banks likely to keep policy “very loose for a long time”.

Concerning the RBA, the London-based consultancy argues that “negative interest rates may yet be needed” despite the Australian central bank’s statements to the contrary.

Overall though, Morningstar’s Tim Wong, manager research, says fixed income remains an essential part of a diversified portfolio.

“We’ve stood pretty firm on the view that high-grade fixed income that has some level of interest rate duration still remains an appropriate portfolio diversifier, especially for risky assets,” he says.

“We think of it as an insurance policy – the bond portfolio should provide a buffer for your overall portfolio”.

is a Morningstar contributor.

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