Q & A

We are often receiving questions from clients that we answer on an individual basis but are sure there are other investors out there with the same inquiries. As such we have decided to run a regular section in the WIRE that covers the more common questions...and answers. This week we address the so called “bond bubble”.

Q. Why would I invest in fixed income when there is a “bond bubble”?

A.

Talk of a bond bubble refers to the low yields available on sovereign bonds around the world, particular the US, Europe and Japan where yields range from 0 to 1.0%. The so called “bubble” is the fundamentally based economic that when interest rates rise the price of FIXED rate bonds decline dynamicly (as opposed to an unsustainable overvalued market such as those often seen in equities, property or tradeable commodities).

By comparison, Australian Government bonds are trading at relatively high yields of around 2.8% for 1 year bonds to 3.75% for 20 year bonds, albeit amongst the lowest yields seen in Australia for many years.

There are a number of reasons the “bond bubble” is not a concern for A$ fixed income investors:

1. It applies only to FIXED rate bonds. If you are convinced rates will rise from here (and we don’t particularly believe this to be the case as detailed below) then you can buy floating rate notes (FRNs) or even inflation linked bonds (ILBs) that perform well in a rising rate environment. This is the number one misconception: rising interest rates only result in falling prices for FIXED rate bonds. There is a world of FRNS and ILBs out there
2. It does not particularly apply to Australia that has yields well in advance of the 0-1% offshore and the likelihood of further rate cuts and/or lower yields for a longer period of time
3. Bubble implies irrational behaviour. Interest rates typically move up and down on economic fundamentals and not over-exuberant speculation. Rates are low for very good reasons and we would argue will remain low for some time
4. Bubbles tend to burst with large losses. Assuming the sovereign you are investing with (e.g. the US or Australian Government) does not default which is highly unlikely, the worst case scenario of a bond bubble bursting is that you receive you $100 face value at maturity and regular interest payments in the meantime, albeit there may be some opportunity cost. In the vast majority of cases this would mean a positive return on a hold to maturity basis and no outright loss
5. What is often overlooked is the much higher returns available on bonds issued by banks and other investment grade companies (fixed, FRN and ILB). These bond issuers need to pay attractive credit spreads on top of base Government yields to borrow at the moment and this provides additional return and protection against rising interest rates for the fixed rate bonds as rising interest rates are typically offset with reducing credit spreads as growth and economic conditions are improving

So the term bond bubble is both inaccurate and not overly applicable to Australia where yields are higher. But if you are still not convinced, invest in FRNs (or ILBs) to avoid the impacts of rising interest rates.

When investing in bonds, you have the opportunity to lock in low risk returns that are significantly higher than term deposit rates and assuming the issuer does not go broke, the yield to maturity rate you locked in is the return you will receive and the worst case scenario on a hold to maturity basis. Hardly a bubble type scenario.

As an aside, we are not convinced there is a bubble in US and European sovereign bonds either with low growth and low interest rates set to remain for some time.

We invite readers to send any questions they have to thewire@fiig.com.au and each week we will endeavour to answer the most common queries.