Investing

The November bond market sell-off – What you need to know

  • 06.DEC.2016
  • Ian Martin,  XTB

The November bond market sell-off

To break down what happened in bond markets in November 2016:

  • We first highlight what happened to government bonds;
  • Then we look at the major bond index to see what parts of it were impacted the most; and
  • We apply the same thinking to corporate bonds and therefore XTBs.

 

Government bonds

As widely observed in the media, Government bond yields in the US and Australia have been rising. This means bond prices have fallen, since the US election.

Chart 1 shows the change of Government bonds with different maturities from October to November 2016.  We have shown both shorter-term bonds (up to 5 years to maturity) and longer-term bonds (7,10, 20 and 30 years to maturity).  Plotting the yields of bonds versus their maturity is called creating a ‘yield curve’.

The yields of both shorter and longer-dated bonds increased (prices fell) by different amounts.  But what about the bond price changes that resulted?

CHART 1: 1 month change in yield to maturity November 2016

Bond Market sell-off: Monthly change in yield to maturity
Source: Australian Corporate Bond Company and Bloomberg

Chart 2 shows the change in price of each of these bonds as a result of these yield changes.  The price of a bond with a much longer maturity is more sensitive to interest rate movements than the price of a shorter-dated bond.  So it makes sense the longer dated bonds had the most negative returns.

Chart 2 Monthly change in price of Government bonds

Bond Market sell-off: Monthly change in price of Government bonds
Source: Australian Corporate Bond Company and Bloomberg

The price of longer-dated government bonds fell by up to 6.91% during November.  This is the price action journalists were referring to. You’ll note the shorter-dated government bonds did not fall as much because they have lower duration. Therefore their prices are less sensitive to rate increases. The price of 2 year bonds maturing in Jan 2017 fell less than 0.60%.

The average maturity of XTBs is currently 3.06 years. So the impact of the November global bond sell-off was more in line with the fall in prices of the shorter-dated government bonds.

What about the Bond Index and ETFs?

A bond index (or an ETF tracking it) is made up of all the eligible bonds. But because index providers break down indices by maturity buckets, it is also possible to see which parts of the index have underperformed or outperformed the total index.

Table 1 shows the returns of Australia’s most well-known index, the Bloomberg AusBond Composite Bond Index. This has fixed rate investment grade bonds issued by Australian Governments, Supranationals and corporates.  The data is broken down into the specific maturity buckets that make up the index.  We have also shown the returns of those maturity buckets over different time periods.

The overall index fell -1.44% from October to November 2016.  This is the blended performance of all bonds in the index.

However, if you look at the component parts you’ll see the zero to 3 year part of the index had a -0.06% return, while the 10+ year part of the index, which incorporates longer-dated bonds, produced a -4.07% return.

Table 1 – Returns of the Bloomberg AusBond Composite Bond Index and Sub Maturity Indices as at 30 Nov 2016

Index Maturities 1 month 3 month 6 month 12 month
Composite Index All maturities -1.44% -2.92% -0.49% 3.44%
Composite Index 0-3 Years -0.06% 0.00% 0.85% 2.51%
Composite Index 3-5 Years -0.71% -1.32% 0.24% 3.33%
Composite Index 5-7 Years -1.49% -2.81% -0.44% 3.85%
Composite Index 7-10 Years -2.37% -4.97% -1.33% 4.53%
Composite Index 10+ Years -4.07% -8.46% -2.93% 4.79%
Source: Australian Corporate Bond Company and Bloomberg

The corporate bonds that XTBs cover are only a sub-set of the Composite Bond Index, so while the data in table 1 gives you a clue about their performance in the 0-3 and 3-5 year buckets, you need to drill down a bit further to identify how XTBs went over these periods.

How did corporate bonds perform?

In Table 2 we add to the data by including the Bloomberg AusBond Credit Index. This is a sub-index of the Bloomberg Composite Index.  This index just has corporate bonds and is also known as the ‘credit’ index because the bond market colloquially refers to the corporate bond market as the ‘credit’ market.

We can then compare the Credit index to the larger Composite Bond Index. Interestingly the Credit Index has outperformed the Composite Bond Index in all maturity buckets in all observed time frames.

Note for the Credit Index, the 0-3 year part had a monthly return for November 2016 of 0.04% (actually went up slightly) while the 3-5 year part had -0.56% return (more duration so more sensitive to the fear of inflation).

Table 2  Returns of Composite Index v Corporate Index

Index Maturities 1 month 3 month 6 month 12 month
Composite All maturities -1.44% -2.92% -0.49% 3.44%
Credit All maturities -0.68% -1.12% -0.89% 4.10%
Composite 0-3 Years -0.06% 0.00% 0.85% 2.51%
Credit 0-3 Years 0.04% 0.32% 1.41% 3.28%
Composite 3-5 Years -0.71% -1.32% 0.24% 3.33%
Credit 3-5 Years -0.56% -0.82% 1.32% 4.85%
Composite 5-7 Years -1.49% -2.81% -0.44% 3.85%
Credit  5-7 Years -1.36% -2.41% 0.45% 5.12%
Composite 7-10 Years -2.37% -4.97% -1.33% 4.53%
Credit 7-10 Years -2.27% -4.58% -0.90% 4.74%
Composite 10+ Years -4.07% -8.46% -2.93% 4.79%
Credit 10+ Years -3.03% -3.20% 1.32% 8.63%
Source: Australian Corporate Bond Company and Bloomberg

XTB performance and their uses

XTBs mostly fall in the 0-3 year or 3-5 year buckets with a small number of 5+ year XTBs. The total return of XTBs during November ranged from positive 1.22% to -1.23%.

From a buyer’s perspective, some 6-8 weeks ago, the Concentrated High  Yield XTB Model Portfolio was yielding an average of about 3.5%.  Late last week we ran a session with Commsec TV comparing this portfolio with the best 3 month and 6 month TDs on offer that day (source: Canstar).  The Concentrated High Yield Model Portfolio had an average of 4.11% and the best TD was 2.85%, which is a 44% uplift from the TD.

Importantly – the capital stability that’s written on the box, so to speak, for corporate bonds and XTBs, was demonstrated in situ during the period of the US election.

 

Note – we’ve covered fixed-rate bonds and XTBs in this analysis.  The floating rate XTBs over bank senior floating-rate bonds do not have duration risk because their coupons float with changing rates.  They were not impacted by the November sell off, which is why they make sense to look at more closely as a ‘cash’ alternative with current yields between 2% and 3%.

Final comments

  • Bonds are often used as a defensive and uncorrelated (to equities) asset in a portfolio.
  • If this is the case, then 0-5 year fixed-rate corporate bonds have done an admirable job in what many commentators will call a “horrible month for bonds”.
  • When commentators talk about the bond sell off they’re probably talking about the much longer-dated bonds.
  • Bonds and XTBs are also used for delivering a ‘defined outcome’. If an investor purchases an individual bond or XTB and they hold it to maturity, they will earn the yield to maturity they locked in at the time of purchase (assuming no default of course).
  • Holding a 0-5 year bond or XTB is a different risk proposition compared to holding a 10, 20 or 30 year government bond.
  • Even in a rising rate environment individual bonds and XTBs add value to portfolios.

 

Call us to discuss this article and how it affects your investment portfolio.

T: 1800 995 993
E: advisers@xtbs.com.au

This article first appeard in Yield matters on 6 December 2016.

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