Have Bonds Moved Too Fast, Too Far?

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While bonds yields have risen on higher inflationary expectations, driven by higher commodity prices and expectations surrounding large US fiscal stimulus, the big unknown is what will happen next?

-Australian bonds suffered biggest negative monthly return since 1983
-Headline ASX performance masks discrepancy between sectors
-Mayhem experienced in rates market could extend into risk assets
-Allocation to inflation-linked bonds will help protect portfolios

By Mark Story

The rollout of the vaccine globally, and a continuum of ballsy global fiscal stimulus measures, along with rising prices, none the least being commodities and oil, have all taken their toll on bonds this year.

Having been caught up in this melee of bond volatility as inflation expectations continue to rise, the Australian bond market was marked down approximately -3.5% in February (in price terms) suffering its biggest negative monthly return since 1983.

Together with its negative return in January, bonds’ most recent antics have put paid to recent performance, having wiped -80% off the bond market's 2020 returns.

Global bond yields rose, with the US 10-year government bond yield rising 37bp to 1.46%, and as of Friday night up to 1.64%.

Closer to home, we’ve witnessed the rapid rise in long bond yields during 2021, with the ten-year Australian Government bond yield having almost tripled since the lows experienced in 2020. The stock market is scratching its head, and trying to second guess what will happen next.

Enter the inflation Jeannie

Confused by all these gyrations heightened talk around inflation? You should be, as so is everyone else. Inflation expectations are many times higher than the low point experienced in March 2020 and have now crept up into the RBA inflation rate target.

Here in Australia, cash rate expectations suggest an RBA cash rate of 3% by late 2028. As at March 12, with three- and ten-year Australian Government bond yields at 0.106% and 1.79% respectively, there is an embedded expectation that cash rates will rise very quickly, surpassing pre-covid monetary policy settings into 'tight' cash rates.

Note that the RBA’s monetary stimulus includes purchasing three-year bonds to hold the yield at 0.1%, while two weeks ago the central bank intervened at the ten-year level as the yield threatened to hit 2.0% in a spate of volatility.

To get an idea of exactly how quickly cash rates are expected to rise, it’s important to note the market's pricing of the future path of cash rates as at 26 February 2021 is nearly three times higher than the market pricing back in October 2020.

Since the RBA began cutting the cash rate after the 2019 Federal election, UBS have been very concerned about net interest margin (NIM) pressure from the impact of low bond rates on banks' free funds and replicating portfolios. During this time, the yields on banks' replicating portfolios have reduced from around 2% to circa 1.5%.

There are still some headwinds to go, but if the yield curve steepening is sustained, UBS suspects it is likely to relieve some pressure from low rates.

Steadying the horses

Meantime, in an attempt to steady the horses, especially in light of the rise in long bond yields, which fly in the face of its commitment to yield curve control, the RBA has expanded its version of quantitative easing (QE) and recommitted to no cash rate hikes until at least 2024.

RBA Governor Lowe didn't rule out expanding QE, noting "if it turns out we need to do more, we can". This hinges on whether the RBA is making sufficient progress on reaching full employment (i.e. the non-accelerating inflation rate of unemployment or NAIRU) and the inflation target. Lowe also made it clear the RBA would use macro-prudential policy tools, rather than higher interest rates, if it needed to tame a booming housing market.

Assuming NAIRU is sub-4%, UBS thinks the implication is the RBA would rather err on the side of easing too much than too little. UBS suspects the most likely macro-prudential policy measures to be implemented are limits on high debt-to-income loans, and increasing the interest rate serviceability floor. But if there’s a rapid increase in investor credit growth, other measures, adds UBS, include limits on interest-only lending and investor credit growth.

But unsurprisingly, interest rate risk – which is the sensitivity of bond markets to movements in bond yields – is now a key risk for fixed interest investors to manage. Given it is featuring a potent combination of record high levels of duration and record low bond yields, Janus Henderson claims the pre-conditions for adverse outcomes from the bond market had been brewing for a while.

As a case in point, the company believes the effect of six years of duration, essentially means that even a 1.0% rise in bond yields, would result in a -6% decline in capital for index investors.

Déjà vu

Those who can cast their minds back a few years may be justified in asking, as in the inimitable words of Winnie the Pooh, haven’t we been here before?

The short answer is yes and no.

There are similarities between the current period and the ‘taper tantrum’ in 2013, and even the period of ‘synchronised global growth’ acceleration in 2016.

Interestingly, while Australian equities have struggled for direction in 2021, the headline performance of the index — the ASX 200 is up around 1.2% year to date — masks the significant performance discrepancy between sectors.

Cyclical sectors have performed strongly, whilst more defensive and high growth sectors have underperformed. Cyclical sectors (materials, energy and financials, which represent of 50% of market cap) do particularly well when bond yields are rising.

Materials have been the best performing sector due to investors wanting to position into sectors with the strongest exposure to the recovery. You only have to look to the index composition in Australia to understand why the market can keep rising while bond yields are rising.

In short, the heavyweight sectors of materials/energy and financials far outstrip the index weight of the defensive sectors.

The worst performing sectors against rising yields have historically been REITs, utilities and consumer staples (13% of the market). That’s because all three have minimal earnings leverage to an acceleration in global growth.

Are risk assets next?

If central banks don't intervene in a coordinated fashion to avoid a 'taper tantrum' style sell-off, Janus Henderson suspects the mayhem experienced in the rates market could extend into risk assets (such as equities and high yield and investment grade credit).

Despite the asset purchase programs and dovish rhetoric from central banks, what’s very clear, the investment company adds, is markets are pricing in an earlier return to the RBA tightening monetary policy than the 2024 conditional commitment Lowe & Co have made.

As a result, markets are now challenging the central banks on whether they will stay the course with forward guidance and yield curve control (YCC) measures over the next three years.

Without putting too fine a point on it, effectively navigating the more volatile rising rate environment at the key turning points will be critical, especially given the magnitude of interest rate risk (duration). So that said, how are we navigating the turmoil?

Nobody knows how much further bond yields will rise in the short term. However, given how unprecedented the speed at which yields have risen already, relative to other episodes over the last ten years, Wilsons suggests further rises in bond yields could be moderate as investors wait to see how further developments play out.

With the market unlikely to be so black and white in discriminating between covid-19 winners and losers, the broker expects stock-specific characteristics to be a more significant factor in performance.

Inflection point to value rotation trade

Whilst rotation swings in markets are never permanent, Wilson’s reminds investors that it’s ultimately companies that can show sustained above-market earnings growth that will help drive portfolio outperformance in the long-term.

The broker expects the current period of rotation to create opportunities among long-term growth plays that are currently unloved.

Examples include Brambles ((BXB)), Carsales ((CAR)), CSL ((CSL)), Domino’s Pizza ((DMP)), NextDC ((NXT)), ResMed ((RMD)), Seek ((SEK)), and WiseTech Global ((WTC)) within the S&P/ASX 100.

Market strategists at Citi suspect there could be a turning point in the second half of FY21. While higher inflation expectations alongside better economic prospects clearly benefit cyclicals and rising bond yields favour financials, Citi reminds investors the investment community still appears underweight the non-growth elements of the equity market.

Citi’s value/growth lead indicator model implies a shift occurring in the second half od FY21, which could coincide with confidence building around projections for rapid recovery. While Citi considers it too early to adjust portfolios for this growing possibility in several months’ time, the broker says it’s something that is worth keeping in the back of one’s mind.

Citi admits the growth versus value is very vulnerable to a correction and there still seems some way to go, but the broker also believes the data look to be changing for later 2021 given the normal lags. Citi expects value EPS growth to accelerate and exceed that of its style counterpart by mid-2021.

Bond strategy

As yields rise, Janus Henderson believes it’s worth taking some duration risk to capture higher yields, especially if markets overshoot.

What higher bond yields present, adds Janus Henderson, especially when cash rates are anchored at close to zero, is very steep yield curves. Hence there’s an opportunity for investors to participate in both the yield and roll-down effect that adds to performance.

If nothing happens in markets over the next year, Janus Henderson believes a ten-year risk free government bond today can deliver a return that's at least twice that of a five-year major bank floating rate corporate bond.

To active managers like Janus Henderson, these are exactly the type of opportunities worth waiting for, even if some volatility in the near-term needs to be tolerated.

While they’ll only know after the fact whether the strategy went too early or too late, the Janus Henderson team have also been focusing on capital preservation strategies to protect against a breakout in inflation expectations.

Janus Henderson has gradually bought into the weakening bond market, with the expectation of higher returns in the future. While a plausible case can be made for bond yields gradually lifting over the medium to long term, the investment company believes the recent sharp price action appears to have brought forward that theme too quickly.

Given the difficulty picking turning points, Janus Henderson is focussed on having the largest active position at the turning point, as it will be too late to position after markets have turned.

The investment company’s sizeable allocation to inflation linked bonds helps protect portfolios against the market's expectation of a sharp lift in inflation.

Meantime, having participated in the meaningful rally of spread sectors, Janus Henderson feels it’s prudent to take some profit, especially while valuations are at peak levels in the post-covid market rally.

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