A Quick Review of Bond Markets
- On the last day of the month CPI printed below expectation and caused the yield of bonds to fall and prices to rise.
- RBA pricing Dec 2018 retraced slightly from a full 0.25% hike now at 1.72% (Chart 1).
- 3 year bond yields increased (prices fell) by a minimal 1 basis point (Chart 2).
- 10 year bond yields increased (prices fell) by 18 bps (Chart 3).
- Therefore, the yield curve flattening reversed towards levels seen in November last year.
- Composite Index Performance -0.27% MoM (Table 1)
- Credit Index Performance 0.03% MoM (Table 1)
- Best performing sector of the Index was Credit 0-3 years +0.27% (Table 2)
January was another month with a steady print of labour data in Australia (15.1k increase in full time employment). In the USA bond market bears had control of the market. The benchmark US 10 year bond ended the year at 2.406%. As I stated in my December note, “many analysts are looking for the US 10 year bond to accelerate to higher levels if it can have several sessions above 2.40%”. In a ‘risk on’ start to the year which saw higher equity markets, the US bond market found few friends and the yield to maturity of the US 10 year bond rose to just over 2.705% and therefore prices sold off.
The Australian Government Bond market also sold off (prices lower yields higher) following the US market right up to the last day of the month when Australian CPI was published. The inflation data was interpreted by most to give the RBA little reason to change rates in the short term.
This brings me to a discussion point that I will raise throughout the year. If the RBA is on hold for 2018 then there are limitations as to how high yields of the 3 year government bond can go.
This is because theoretically the yield of the 3 year bond can be described as the expected average return of the RBA rate over the same period. The longer dated government bonds (for example 10 -30 years) can have a much more complex valuation model which includes the risk premium required for investing for such a long period of time.
Discussions about the yield curve will continue by various analysts.
The Month in Charts
Chart 1: Pricing of RBA Cash Rate to Dec 2018
Chart 2: Yield of 3 Year Government Bond
Chart 3: Yield of 10 Year Government Bond
- The Bloomberg AusBond Composite Index for all maturities (the common benchmark) produced a negative return of -0.27% for the month.
- The Treasury Index for all maturities which is the single largest contributor to the Composite Index produced a negative -0.43% return. I would expect these sorts of results when interest rates rise, because the Treasury Index is just government bonds, many of which have a maturity date beyond 10 years.
- The Credit Index produced a small positive return of 0.03%.
Table 1: Index Performance
|INDEX||As at 31 JAN 2018||1 MONTH||3 MONTH||6 MONTH||12 MONTH|
|Composite Bond Index||All Maturities||-0.27%||0.36%||0.85%||2.75%|
|Treasury Index||All Maturities||-0.43%||0.27%||0.62%||2.45%|
|Credit Index||All Maturities||0.03%||0.72%||1.66%||4.28%|
0 – 3 year corporate bonds produced the best total return of 0.27%.
It is worth looking into sectors of the markets to see where the best returns were to be had.
Table 2: Index by Maturity
|Index||MATURITY||1 MONTH||3 MONTHS||6 MONTHS||12 MONTHS|
|Composite Bond Index||0 – 3 Years||0.24%||0.42%||0.91%||2.14%|
|Treasury Index||0 – 3 Years||0.23%||0.30%||0.63%||1.61%|
|Credit Index||0 – 3 Years||0.27%||0.66%||1.43%||3.29%|
|Composite Bond Index||3 – 5 Years||0.08%||0.22%||0.74%||2.37%|
|Treasury Index||3 – 5 Years||0.06%||0.05%||0.38%||1.50%|
|Credit Index||3 – 5 Years||0.21%||0.71%||1.76%||4.55%|
|Composite Bond Index||5 – 7 Years||-0.24%||0.22%||0.75%||2.65%|
|Treasury Index||5 – 7 Years||-0.25%||0.03%||0.34%||1.78%|
|Credit Index||5 – 7 Years||-0.18%||0.69%||1.78%||5.21%|
|Composite Bond Index||7 – 10 Years||-0.80%||0.20%||0.64%||2.81%|
|Treasury Index||7 – 10 Years||-0.88%||-0.04%||0.25%||2.04%|
|Credit Index||7 – 10 Years||-0.55%||1.02%||2.07%||5.81%|
|Composite Bond Index||10 + Years||-1.02%||0.69%||1.13%||4.33%|
|Treasury Index||10 + Years||-1.02%||0.66%||1.08%||4.36%|
|Credit Index||10 + Years||-1.31%||0.69%||2.02%||6.04%|
With the steepening yield curve (the 10 year bond yield rose by 18 bps while the 3 year bond only rose by 2 bps) indices linked to bonds with a maturity beyond 5 years all produced negative returns.
Terms to be explained
BP: BP is an abbreviation of basis point. It is the unit of measure of interest rates. If the Yield to Maturity moved from 3.00% to 3.01% it would have been said to move 1 bp.
CPI: Consumer Price Index: Is a measurement of inflation in the economy. The RBA has a long term target for inflation of 2% – 3%
RBA Rate: The Reserve Bank of Australia sets a Cash Target Rate. It is the level of the overnight deposit rate. It is the RBA’s main lever for influencing monetary policy.
Forecast RBA Rate. Or Implied RBA Rate: Like most financial instruments it is possible to speculate on the future level of the RBA Rate. ASX 30 Day Interbank Cash Futures are the most observable financial instrument. It is possible to lock in (hedge) the RBA rate using the futures contract up to 18 months ahead.
Bond Yield / Price Relationship: The relationship between a bond’s yield and its price are inverse. As the yield of a bond increases its price will fall. As a bond’s yield falls its price will rise.
Yield Curve: Yield curve describes the relationship between bonds with different maturities by the same issuer. If the 3-year Australian government bond had a YTM of 2.25% and the 10-year government bond had a yield to maturity of 3.00% the difference is 0.75%. We could say the yield curve between 3 year government bonds and 10 year government bonds was 75bps positive.
Yield Curve Flattener: Is when the yield of a longer dated bond gets closer to the yield of a shorter dated bond assuming the yield curve is positive. If the yield of the 3 year government bond moved from 3.00 to 2.75 and the 10 year government bond moved from 3.75% to 3.25% we would say the yield curve flattened by 25 bps. The yield curve started at 75bps (3.75 – 3.00 = 75bps) and moved to 50bps (3.25% – 2.75% = 50 bps).
Bloomberg AusBond Composite Bond Index or Composite Index: Possibly the largest bond index for Australian dollar denominated bonds. It is often used as a benchmark to describe bond returns and many fund managers refer to it as their benchmark when constructing portfolios. The index is heavily weighted towards government, state government and government backed issuers such as the World Bank. These issuers currently represent over 88% of the index. Often these bonds are long dated and have yields below corporate bonds of the same maturity. Corporate bonds make up less than 12% of the index.
Bloomberg AusBond Credit Index or Credit Index: An index that contains only Australian dollar denominated corporate bonds (which includes bonds issued by banks and overseas companies). The Credit Index is also part of the Composite Index.
Sub indices: Bloomberg classifies bonds into small sectors such as corporate bonds with maturities between 0 and 3 years or government bonds with maturities between 7 and 10 years. This is helpful for commentators to describe which parts of the bond market contributed to the overall index’s return.
Index Total Return: The return an investor would have made if they had invested in all the bonds in the index. It assumes funds from coupons and maturing bonds are reinvested in the remaining bonds in the index.
Bear Market: Commentators describe a bear market for bonds as one where yields increase and prices decrease.
For more definitions so our glossary.
Source: Bloomberg & Australian Corporate Bond Company