Bonds suffer volatility and retreat in March but are up for the year.
To discuss movements in fixed income we go back to our basic model, based on the following building blocks:
- What have central banks done?
a. Crisis response from the RBA has seen cutting of the official rate by 0.50% from 0.75% to 0.25% during Q1.
b. The US Federal Reserve, who had more room to move, dropped their Fed Funds rate by 1.50%. The lower end of their target rate is now 0%.
- How have government bonds in each maturity responded?
a. 3-year Australian government bonds have fallen by 0.67% to 0.25%
b. 10-year government bonds have fallen by 0.61% to 0.76%
c. The US market saw larger falls in yield:
i. 3-year 1.32% to 0.29% and
ii. 10-year 1.25% to 0.67%.
- How have corporate bonds moved in comparison to government bonds?
a. Corporate bonds have been repriced and widened as investors demanded greater yield to hold a corporate bond. The average asset swap spread (a proxy for credit spread) of the Credit Index in Australia increased by 0.47% during Q1. This is an average number and given for illustration purposes.
- Index returns
a. The Government Bond Index returned 4.08% YTD
b. The Credit Index returned 0.75% YTD
c. The Composite Index (dominated by government bonds, corporate bonds represent only 12% of this Index) returned 2.99% YTD
d. Credit’s lower performance reflected credit spreads widening versus government bonds. Credit indices generally have shorter dated bonds than the Government Index.
Central bank activity
At the start of the year the Australian market was already pricing in an official RBA cash rate of 0.50% at the year end. The response to COVID-19 brought a new dynamic in the economy and accelerated RBA action. The RBA made their first cut of 2020 at the meeting on 3 March 2020. This was followed by an emergency cut on 19 March 2020 as part of coordinated central bank action.
The US Federal Reserve, who had been raising rates since 2015, had more fire power than the RBA. They have cut rates by 1.50% since February.
To add further support to the market, the RBA began targeting 0.25% for 3-year government bonds as part of its quantitative easing.
Both the Federal Reserve and the Reserve Bank of New Zealand have included policies to support their corporate bond markets. The FED has even provided some support for fixed income ETFs.
CHART 1: RBA and Federal Reserve Official Interest rate movement
The 3-year government bonds have steadily decreased since the start of the year. They moved from a yield of 0.90% to 0.27% at month end – a fall in yield of 0.67%. As the RBA has stated a target of 0.25% as part of their QE package, it is unlikely that yields will increase significantly from this level. Stresses on supply dynamics could cause a further fall in yields, but this would likely be short lived as new supply will be forthcoming due to government deficits.
The 10-year government bond has shown considerable volatility. Yields have fallen by 0.61% to 0.76%. After touching a low of 0.61% they spiked to 1.49% around the time of the RBA QE announcement. This illustrates that even government bonds can suffer from liquidity and volatility in times of stress.
CHART 2: 3 and 10 year Government Bond Yield to Maturity
Turning to total returns, Table 1 shows that even following a negative return for very long dated government bonds in March, this index has returned 6.45% YTD.
The 3 to 5-year part of the index has returned 2.46% YTD.
Table 1 Return of Treasury Index
|TREASURY INDEX||MARCH 2020||YTD|
Credit spreads widened considerably over the quarter. This was due to concerns over the effect of COVID-19 on the economy and the ability of companies to service their debt, combined with a lack of liquidity. Note: Credit spread is the premium investors require to hold a corporate bond instead of a government bond.
The average credit spread of the Credit Index moved from +84 bps to +131 bps in Q1.
Chart 3: Credit Index – Average Credit Spread
This use of average credit spread has limited benefit – greater insight is gained by comparing parts of the index on a total return basis.
Table 2: Treasury vs Credit: Index Total Return
|INDEX – Treasury / Credit||MARCH 2020||YTD|
|Treasury: All Maturities||0.23%||4.08%|
|Credit: All Maturities||-1.46%||0.75%|
|Treasury: 0-3 Years||0.49%||1.15%|
|Credit: 0-3 Years||-0.34%||0.36%|
|Treasury: 3-5 Years||0.75%||2.46%|
|Credit: 3-5 Years||-1.08%||0.96%|
|Treasury: 5-7 Years||0.85%||3.64%|
|Credit: 5-7 Years||-2.27%||0.86%|
|Treasury: 7 -10 Years||0.77%||5.29%|
|Credit: 7 -10 Years||-3.43%||1.00%|
The 3 to 5-year index for credit bonds produced a return YTD of 0.96% vs the equivalent government bonds of 2.46% (Treasury Index). We estimate this is approximately 0.45% in YTM under-performance by the credit bonds.
In the 7 to 10-year sector, credit returned 1.00% while government bonds returned 5.29%. We estimate this is approximately 0.55% in YTM worth of under-performance.
Credit premium for longer dated corporate bonds has widened by more than shorted dated corporate bonds.
Note: All maturity buckets for corporate bonds showed a negative return for March when markets showed their most stress for the year.
The effect on banks
The major questions are – can banks fund themselves and will they allow the transmission on credit to corporates, and at what price?
3-month BBSW (the price at which banks can borrow from other banks and institutions for 3 months) is currently 0.33% or 8 bps over the RBA Cash rate of 0.25%.
This is considered in the long term average range. This implies their short term funding is not under stress.
Chart 4: BBSW Funding Spread
By focusing on two Westpac bonds we can see the cost of funding has increased, but to a lesser extent than during the GFC.
Westpac 2026 bond (white line) – credit spread has increased from a low of 80 bp to 138 bp.
Westpac 2023 bond (blue line) – credit spread has increased from 56 bp to 105 bp.
Banks in Australia are not currently providing liquidity to corporate bond markets. They are tending to work on an order only basis for clients, which is a factor of lower liquidity in corporate bond markets.
Chart 5: Westpac Credit spread 3 and 6 year Maturity