As we exit more than two decades of engineered economic landings, markets are struggling with a return to ‘normal-settings’ and potentially lower investment returns from traditional areas like shares.

It was central banks and governments ‘doing what’s necessary’ to combat extraordinary periods of volatility, caused by events like the global financial crisis and COVID-19 pandemic, that led to a series of engineered landings. In turn, that intervention sheltered many types of investments from the full impact of those events, and even pushed asset prices higher during periods where a decline would have been a normal response.

Take the US for example. Its equities market has recently shaken off a period of softness and is back in bull market territory. This is at a time when the Federal Reserve is still in rate hiking mode, unemployment is increasing, and business activity is slowing.

It is no less problematic in Australia. The Reserve Bank has indicated rates have not yet peaked, corporate activity is slowing, people are spending less, and unemployment is expected to increase. The S&P/ASX 200 only managed a 6% rise in the first half of the year, far less than the average 14% rise in international equities. However, the chances of a soft-economic landing are now slim at best, and even if we skirt a recession, it is not going to be a pleasant ride back to growth.

Increasingly, market observers have been reaching the same conclusion private wealth management specialists, JBWere, has been telling its clients all year – that future corporate earnings are being priced too high by the market, creating conditions for a downward market rerating.

It begs the question, what are more attractive risk/reward options? Given current market conditions, it’s hard to go past fixed income, better known as bonds.

Can fixed income deliver good returns?

Many private investors ignored fixed income while government’s intervened to support asset prices and drive down interest rates. However, interest rates have surged over the past 18 months, and coupled with equity market volatility, fixed income is now very much front of mind.

Since early 2021, yields on Australian Government Bonds have doubled, and corporate bonds look appealing. High quality corporate bonds, like Coles 2029 bond, is yielding just under 6%, while Australian Bank Subordinated Bonds are yielding close to 7%, and some higher yielding bonds further up the risk curve can achieve between 7%-9%.

As growth slows and inflation plateaus, the market is pricing in a higher chance of a recession in the next year. Investment grade bonds can be viewed as a safe haven, which can provide investors with income in volatile times, with reduced risk of capital losses compared to equities or property.

What about the interest rate outlook?

Bonds typically come in two forms – fixed interest coupons or a floating rate. If an investor believes interest rates are headed higher they can allocate a portion of their portfolio to floating rate bonds, which move up and down in line with interest rate expectations. Coupons on these instruments reset on each payment date (which can be quarterly or semi-annually in most cases).

On the other hand, if an investor believes interest rates have peaked, they may allocate a higher portion to fixed coupon instruments, locking in a guaranteed return until the bond matures.

As most bonds can be sold on the Over-The-Counter (OTC) market, investors should be aware that the resale value of a fixed coupon bond may fall if interest rate expectations rise, however, the rate of return will remain constant until the bond matures.

Companies pay dividends, so why bonds?

Certainly, share dividends can be a component of the income side of your portfolio, however, there are significant differences in performance to bonds.

Firstly, interest payments and frequency of payment on bonds are locked into the terms and conditions. They do not change based on the underlying company performance, offering investors certainty of income.

In comparison, share dividends strongly rely on the performance of the company, and can also be impacted by external factors, as we saw during the early stages of the pandemic when banks had a dividend payment cap placed on them by the regulators.

Share dividends are also more influenced by the boom-bust economic cycle.

Consider a resources stock over 10 years. It may pay high dividends during a resources boom but lower dividend payouts or even halt dividends during a downturn. In comparison, bonds with that same company would have interest payments locked in throughout the period. Of course, this is viewing the investment from an income perspective, and does not consider any lift or decline in a company’s share price over the timeframe.

It highlights that as we seek to smooth out long term returns, bonds have a place not just in times of turbulence but throughout the economic cycle.

Examining Credit Risk

Bonds are issued with a rating by an international Credit Agency (S&P, Moody’s, Fitch), with the highest quality bonds rated AAA (such as US Government Bonds). The higher the credit rating, the lower the yield on the investment, given the lower risk of default. Investment grade bonds are considered higher quality, as they typically carry upper band ratings.

Conclusion

Fixed income is a source of portfolio diversity and well placed to have a positive impact on the overall risk weighting of your investments. They provide a source of reliable and consistent income and given the immense size of the bond universe, they can often be tailored to suit your specific requirements.

Please contact your private banker or talk to us at NAB Private Wealth

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