There are five things you should think about when considering corporate bonds in a rising rate world:
- Bond tenor and duration risk
- When will rates rise, and are you holding to maturity?
- The benefits of higher yielding fixed-rate XTBs over floating rate TDs – carry.
- The Maturity Ladder approach – holding fixed-rate exposure, but where rate increases are your friend.
- Floating-rate bonds.
1. Duration, Duration, Duration
In the wake of the US election, there were many commentators suggesting an imminent crash in bond markets. This view was based on an expected jump in US inflation. In reality, bond markets globally did fall in price (yields rose), only to recover later.
When reading such reports, the first thing to focus on is duration – what duration bonds are being referred to? When it comes to interest rate sensitivity there is no single ‘bond market’ – some bonds have 1 year to maturity and others have 30. Bond prices move inversely to changes in bond yields, which are driven by actual changes in rates or inflation, or expectations of future changes. The degree of bond price impact depends on a bond’s duration.
Example: The duration of a 1-year bond might be 0.8 and a 30-year bond might be 20.
A 0.5% jump in bond yields would result in a minor 0.4% (0.8 x 0.5%) drop in price for the 1-year bond, but a considerable 10% (20 x 0.5%) drop in price for the 30-year bond.
Duration matters when you’re thinking about bond markets and interest rates.
Reports of potential bond market crashes related to much longer-dated, very large government bond markets around the world. Long duration bonds are very sensitive to interest rate and inflation expectations. Investments in both direct bond holdings or bond managed funds or ETFs are more sensitive to changes the longer the duration of the bonds held, or the duration of the index.
Corporate bonds in Australia are short-dated securities – the average tenor of XTBs in July 2017 is around 3.5 years. They don’t have the same degree of interest rate sensitivity as longer-dated bonds.
2. If rates are increasing – when will they increase?
There are a number of different views on this, but currently the Inter Bank Futures contract on ASX is implying a 25bps rate increase by August 2018, with a further increase later that year. ASX publishes a chart on this which provides a consensus of market professionals’ views via the cash rate implied by trading in a very liquid contract on ASX.
If you agree with this, a 3.5 year fixed-rate XTB bought today will be a 2.5 year (or less) XTB in Q3 and Q4 2018. So the effect of an interest rate rise will have less of an impact on the price. Remember, the duration of a bond and its term to maturity aren’t the same unless you’re looking at zero-coupon bonds. Fixed-rate bonds pay significant coupons, which have the effect of causing a lower duration number for a bond relative to its tenor or term.
What is duration?
A. Duration is correctly described above as the rate of change of a bond’s price with respect to a given change in the bond’s yield (Modified Duration).
B. There is also a different, but related way of looking at duration. This is the duration of a bond being the weighted average time in years until you’ll be paid back the bond’s full cash flows (Macaulay Duration).
A 4-year high-coupon paying bond will have a lower duration than a 4-year low-coupon paying bond. This is because you get some of your return from the higher coupons earlier. Duration is mostly referred as definition A, but B provides a handy way to visualise it in terms of a bond’s tenor and cash flows.
- Let’s assume the average 2.5 year XTB in August 2018 now has a duration of 2.
- If the cash rate was increased by the RBA by 25bps, this average XTB will drop in price by 2 times 0.25%, or a price fall of 0.5%.
The point is – shorter dated bonds are not dramatically impacted by yield increases of this magnitude.
Am I holding the bonds to Maturity?
With such short-dated underlying bonds, does any of this matter for investors holding to maturity? From our experience, 95% of XTB investors are exactly this. For these investors, it’s irrelevant what happens to rates. Rate increases or decreases will not impact the $100 maturity payment.
For buy to hold investors the key questions become:
- Are they happy with the yield to maturity on the day they invest, and
- Are they comfortable with the bond issuer’s credit risk.
More next week
Mark-to-market is an important discipline. With rate rises potentially on the one to two year horizon, the next logical question we’ll look at next week is: “If I bought XTBs today and rate rises do eventuate, would I be better off staying in a floating rate world, such as TDs?”