​Jay Sivapalan, Portfolio Manager, explains that with the 35 year bull market in bonds and central bank accommodation coming to an end, complacent passive fixed interest portfolios are exposed to the index’s high levels of interest rate risk and compositional skew towards low return investments.

An impressive run

It’s hard to believe, but back in August 1985, the Australian cash rate was a shade over 19% and the yield on a 10 year Australian government bond was 16.5%. 35 years later, the cash rate is 1.5% and the yield on a 10 year government bond is around 2.6%.

Over this period, the Australian fixed interest sector has been in a structural bull market, propelled by the shift from a high to low inflation environment and demographic factors which lowered real rates. More recently, conventional and unconventional monetary easing has driven yields even lower.

For investors in the sector, the last 35 years have generated handsome returns, even allowing for the 1994 bond bear market. Returns of 9.5% p.a compare favourably to 12% p.a. from the Australian share market and 7.6% p.a from cash over this period.

[caption id=”attachment_225224″ align=”alignnone” width=”680″] Source: Chart 1: Bloomberg, as at 30 July 2017. Chart 2: Source: Janus Henderson Investors, Bloomberg, Ausbond Indices, UBS, SBC Brinson. Spliced history of Australian Bond market returns. As at 30 June 2017. Forecast numbers are estimated projections only. ^CYTD 2017.[/caption]

Beware the bull complacency trap

A common trap that investors can fall into is becoming complacent about the risks that may be building up in their sector exposures after a prolonged period of structural change and good returns.

With the global economy enjoying a cyclical recovery and central banks signalling a desire to begin withdrawing high levels of policy accommodation, we would like to draw investors’ attention to two sources of risk embedded in the sector benchmark, the Bloomberg AusBond Composite 0+ Yr Index (Benchmark), that have built up progressively since the Global Financial Crisis (GFC).

Lengthening Benchmark duration = more interest rate risk

Just because the level of interest rates are low by historical standards doesn’t mean that a small rise in rates will have a limited impact on sector returns. Investors need to be aware that since 2009, the duration of the Australian fixed interest sector has risen from around 3 years in mid-2009 to around 5 years currently.

In 2009 when bond market yields averaged around 5.5% and duration was 3 years, investors’ exposure to interest rate risk was such that a 1% rise in bond yields would have resulted in capital loss of 3% of capital, delivering a total return of around 2.5% (i.e. the income of 5.5% minus the capital loss of 3% from rising bond yields).

Today, with average bond market yields of around 2.5% and the duration of the Benchmark around 5 years, a 1% rise in bond yields would result in capital loss of 5% delivering a total return of -2.5% (i.e. 2.5% income less 5% capital loss). A 0.5% lift in yields would result in flat returns (i.e. 2.5% income less 2.5% capital loss).

Chart 3: Australian average bond market yield and modified duration

Lengthening Benchmark duration makes investors more sensitive to rate rises

[caption id=”attachment_225235″ align=”alignnone” width=”680″] Source: Bloomberg, as at 11 August 2017. Date is monthly to December 2016, daily from January 2017. Australian bond market based on the Bloomberg AusBond Composite 0+ Yr Index.[/caption]

With the Reserve Bank of Australia Governor indicating that the next move in rates is likely to be up, investors need to be mindful of the interest rate risk in the sector Benchmark. Over the last few years, investors in passive fixed interest products have enjoyed a good run as interest rates fell and the duration of the Benchmark lengthened.

Looking ahead, investors in such strategies need to be aware of their exposure to capital loss from even modest rises in rates. By way of example, the yield to maturity on the Benchmark lifted from 1.98% at the end of July 2016 to 2.43% at the end of July 2017. With the duration of the Benchmark at historically high levels, resultant capital loss more than offset any income, with returns down 0.24% over the period.

We believe active fixed interest strategies or absolute return strategies, where managers are not bound to hold duration at Benchmark levels, are well positioned to preserve investors’ capital in a rising rate environment.

Benchmark compositional risk: more lower returning Government debt, less diversification

Since the GFC, there has been significant change to the composition of the Australian fixed interest Benchmark as corporates de-levered and governments borrowed more as fiscal policy was eased.

In a sense, the heavy issuance of increasingly longer dated government debt (federal, state, supra national) combined with corporate deleveraging hastened the ‘crowding out’ effect that we have seen in the Benchmark. As a result, the market weight of the higher yielding credit sector in the Benchmark has fallen from some 36% in 2008 to around 8% in 2017 currently.

Chart 4: Composition of the Bloomberg Ausbond Composite 0+ Yr Index

[caption id=”attachment_225213″ align=”alignnone” width=”680″] Source: Bloomberg. As at 30 June 2017. *30 June 2017.[/caption]

Investors in passive index strategies have progressively lost access to both the higher yields available in the credit sector and diversification benefits of broader holdings in the Benchmark. As touched on earlier, the issuance of longer dated government debt has increased the interest rate risk embedded in the Benchmark. While we expect rates to rise, we see a range of structural factors limiting the extent of any sell-offs.

If we remain in a broadly lower rate environment, the opportunity cost of investors in passive index strategies not being able to access higher weightings to credit in their portfolios has risen steadily since the GFC. As for building interest rate risk, active fixed interest strategies where managers are not bound to hold credit allocations at Benchmark weights increase the scope for investors to get higher yields and better diversification from their sector exposures.

The past year highlights the importance of interest rate management in navigating the gradual reversal of the bond bull market.