Warren Buffet recently pointed out that income available to investors in 10 Year US Treasury bonds has fallen 94% since the bond bull market kicked off in 1981. Currently, for the pleasure of handing over your hard-earned cash to the US government for ten years, they will hand you back 1.45% p.a. A bargain, for them.
Similarly, in Australia, and after much recent QE activity by the RBA to keep rates down, you can earn 1.69% p.a. on your money by handing it over to the federal government for 10 years.
Unfortunately, the bad news does not end there. Since November, The Ausbond composite index is down almost 4%. Thus, investors who were using “safe” fixed income funds for the defensive part of their portfolios have been smoked.
The reason for this poor outcome is that recent weeks have seen the largest moves in long term interest rates since 1994. As the economy picks up and inflation has become the topic on everyone’s mind, markets got spooked and started to push interest rates up – and the value of bonds down. This was met with the full force of the RBA’s money (printing) gun and rates have now been contained, but at these levels they simply cannot go much lower.
And so we have a conundrum – where do investors go to get safe fixed income investments in the current rate environment?
Most fixed income ETFs in Australia passively track an index. During the great bond bull market this has been a good investment strategy because the indices were designed to measure the market (rather than to act as investment portfolios) and the market has been going up. In measuring the market, the indices include all outstanding bond issues in the segment they are tracking. This has meant that they have held a large “duration” exposure (sensitivity to changes in interest rates from longer dated bonds). Being “long duration” in a bull market is great. Not so much when the market turns, as it has recently done.
eInvest’s actively managed fixed income ETFs have a very low exposure to duration and have therefore increased by around 1% during the time the Ausbond composite has fallen by 4%. Our managers also have an active overlay strategy to minimize volatility and down-side risk, which has contributed to performance. The past few months have been a cautionary tale for investors in index tracking bond ETFs. Historically low rates cannot continue a downward trajectory, and recent moves have indicated the market is expecting rates to rise, particularly at the long end of the rate curve. The heavy exposure of fixed income indices to duration – because they must measure every bond issued in the market – means they are highly exposed to interest rates going up. The RBA can fight this for a while, but the economic growth the RBA wants is inconsistent with historically low rates, particularly longer-term rates.
So fixed income investors beware. Your recent pains may be a harbinger of things to come. In this historic low-interest rate environment, it might be time to go active in fixed income.
Disclaimer: Please note that these are the views of the writer, Tamas Calderwood, Distribution Specialist at eInvest and is not financial advice. To find out how to invest in our active ETFs, visit here. The product disclosure statement and more can be found at www.einvest.com.au. If you’d like to keep learning further, please feel free to follow any of our socials listed below.