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Changing yield curves are an opportunity to shift your fixed income strategy

by Alen Golubovic | Sep 23, 2014

US Treasury bond yields

The upward shift in the US Treasury yield curve is reflected in the chart below:

Overall, US bond yields are up about 12-17 basis points between to 3 year and 30 year points on the curve. While the 10 year Treasury bond yield is up 16 basis points over the month , the difference in yield between 5 year and 30 year Treasury bonds has slightly decreased, as the Federal Reserve signalled that it will raise short-term interest rates while inflation remains below expectations.

Last week, the Federal Reserve raised their median estimates for the federal funds rate (which is the US equivalent to the cash rate) to be 1.375% versus 1.125% in June. The end 2016 estimate was pushed up to 2.875% from 2.50%, while the end 2017 estimate was moved up to 3.75%. These higher estimates contributed to the increase in US Treasury yields, particularly at the short end of the curve.

While US Treasury yields have risen this month, the US dollar climbed to its highest level since 2010 against a broad range of currencies. That’s transformed losses into gains for most foreign bond holders who have invested in US dollar bonds. The US currency has appreciated so much that US Treasuries held by foreign investors were the developed world’s best performing sovereign debt this quarter for investors based in currencies outside of the US.

Australian government bond yields

Meanwhile, the Australian bond yield curve has shifted higher over the past month. The 10 year Australian Government bond yield is up 19 basis points compared to a month ago. The longer end of the curve has seen marginally higher increases in yields versus the shorter end. This is reflected in the chart below:

Implications for fixed income portfolios

Corporate bond investors have seen their returns impacted over the past month by these increases in sovereign bond yields. However, Australian bond investors who have invested in US dollar bonds would have seen their returns on the US dollar portfolio protected by the appreciation in the US dollar.

For those who want to protect their fixed income returns against further increases in global bond yields, we would suggest an allocation to shorter duration US dollar bonds. The strengthening of US dollar can provide protection against rising bond yields for foreign investors in US dollar bonds, while the shorter duration can limit capital losses when bond yields rise.

For investors who are concerned about the risk of an increase in interest rates in the shorter term, an increased allocation to floating rate bonds would be appropriate strategy. Floating rate bonds pass through any increases in short term interest rates by paying a higher floating rate component in their overall return.

Alternatively, you may be of the view that Australia is in a sustained period of low economic growth but high inflation, which will continue to keep bond yields low in the coming years. If you believe this scenario, then buying inflation protection would be one appropriate course of action through an allocation of Australian inflation linked bonds.

Whichever your perspective, the yield curve movements represent an opportunity to discuss and revisit your bond portfolio with your FIIG representative and form an appropriate strategy based on that interest rate / yield outlook. FIIG Securities offers a range of different bonds, including US dollar, floating rate and inflation linked bonds to suit your overall investment strategy.

Note at the time of writing bond yields have fallen 5 – 10 bps from those in the charts above.

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