Interest rates are low and seem likely to remain low for some time. It is something we all may have to accept.
In Australia, the RBA Cash Rate is at a record low 1%, with analysts predicting it will fall further – perhaps to 0.5% by early next year. The 10-year government bond has also hit a record low in yield, trading below 1%, only slightly above the 3-year bond.
In the US, the yield curve has inverted. Currently, the 10-year treasury bond is trading below the 2-year bond. This is a phenomenon many see as a recession indicator.
The impact of rate cuts on investors
When RBA interest rates drop, bonds and other products linked to this rate can also be impacted – such as term deposit rates and bank savings rates. On the plus side, mortgage rates and the cost to borrow money also generally drop. So while we celebrate the possibility of a lower mortgage rate, the income we receive on our savings is also likely to drop. As is often the case with investing, there’s a bad and a corresponding good that comes with the change in interest rates.
The relationship between interest rates and bond yields
A recent global survey of individual investors conducted by NATIXIS Investment Managers found that many do not understand how rate movements affect their fixed income investments. Only 3% of respondents fully understood the relationship between bonds and interest rates. This is significant because of the 77% who invested in bonds, 54% do so to generate income.
Have you adjusted your expectations accordingly?
The survey went on to find that there is a sizeable gap between the return investors expect to receive from their portfolio and what professional investors see as realistic. In Australia this expectation gap is 85%. Investors expected an annual return of 11.9% above inflation while financial professionals felt that 6.4% was a more realistic return.
With the interest rates on our savings so low, the risk that investors need to take to achieve meaningful returns is heightened. When the cash rate was considerably higher, achieving double digit returns across your portfolio would be more likely than when the cash rate is at 1%. Investors have a difficult choice – accept the lower returns which come with the ‘safer’ fixed income investments, or climb up the risk ladder and hope to not encounter a snake!
At times like this, having a properly balanced and diversified portfolio can help. Fixed income investments may be offering a lower return than they were in the past, but don’t forget why you invest in them – it’s often for the predictability, steady income and their generally negative correlation to shares. They can act as ‘padding’ to your portfolio should the share market experience a downturn.
With the media focusing so much on yield curves, let’s look a little more into what they are and what each of the key yield curve shapes means for investors and the broader economy.
What is a yield curve and why should you care?
A yield curve is a graph showing the relationship between interest rates earned on lending money for different durations. The shape of the yield curve illustrates the relationship between expected yields and time to maturity. It gives an idea of expected future interest rate changes and economic activity. The shape of the yield curve can be influenced by factors such as monetary policy, investor expectations, and inflation.
Three main types of yield curves
There are three main yield curve shapes; normal, flat and inverted.
Normal yield curve
A normal yield curve is upward sloping with longer maturity bonds yielding more that shorter term bonds. This assumes that holding longer term bonds is riskier than holding shorter term bonds, because there is more risk to interest rate fluctuations. A normal yield curve is thought to be an indicator of future economic expansion and inflation.
Inverted yield curve
An inverted yield curve is downward sloping with shorter term yields higher than longer term yields. This shape indicates that investors may be pessimistic about future growth, inflation and the path for short-term interest rates.
This is generally due to recessionary fears. Investors see the ability to lock in the yields available from longer dated bonds more attractive. This increases demand for this end of the curve. More demand means higher prices and lower yields.
With a flat yield curve there is an insignificant difference between short and long term yields. There is little to no risk premium for holding a longer dated bond. This can be an indicator that investors are unsure about future economic outlook. They can occur even when the economy is recovering from a recession.
What shape are we?
So considering that inverted yield curves are often indicators of an economic slowdown, investors should be treading cautiously. In the USA, there has been a yield curve inversion before each of the last seven recessions.
A determination of investment objectives and stress thresholds along with a re-calibration of earnings expectations is key. With equity markets soaring it is hard not to be lured into the returns they have shown. But with any high risk investment, they can fall just as dramatically as they can rise. Hovering at near record highs, a significant correction is not inconceivable. If you’ve benefited from some of the significant gains of recent times, perhaps now is the right time to leave the volatility behind and park this money in an investment which offers more stability and predictability. It’s a tough choice of when to make the move. But, it’s worth considering whether moving a little too soon could be a better option than leaving it too late?
Think about bonds as a wealth storage vehicle
Corporate bonds can provide a safe harbour during turbulent times, whilst still providing regular, predetermined income and yields competitive with TDs¹ and savings accounts. They are widely used by institutional investors, where they are traded in the over the counter (OTC) market. XTBs and bond ETFs have enabled ASX investors to consider this same approach by lowering the minimum investment hurdles required and providing access to corporate bonds on ASX.
Investors in corporate bonds are basically lending money to that company. In exchange, the company promises to pay back the principal of the bond plus regular, predetermined interest payments. These payments are known as a coupon (subject to no default).
Corporate bonds sit high in the corporate debt hierarchy – they are just below TDs but well above hybrids and shares.
Generally, the lower the ranking a security is, the higher the risk and potential reward associated with it. The higher the ranking, the more repayment of investors is prioritised in the event of a default.
Corporate bonds could be a way of squeezing a little more return from your investments, while still benefiting from those core principles of fixed income – low volatility, defined income and set maturity dates.
Where corporate bond XTBs fit
XTBs provide exposure to the underlying corporate bonds of top ASX listed companies. Unlike bond funds or ETFs, they allow investors to pick and choose individual bonds from companies they want to invest in. By essentially mirroring the fixed income attributes a specific corporate bond, XTBs offer another key advantage over a bond fund or ETF. They provide investors with a predetermined maturity date and set coupon payment dates and amounts. If you are looking to add some predictability to your portfolio, XTBs should be on your radar.
Being traded on the ASX means XTBs can be bought and sold through a broker or online trading account like shares. Not only can investors lock down specific dates to receive coupons they also know the date of maturity, when the face value is returned (subject to no default). And, they have the flexibility to sell the XTB prior to maturity if they choose to.
While the quest for yield seems to get increasingly difficult for investors, perhaps the best approach is to go back to basics. Ensure your portfolio is well diversified and each asset class is working as hard as it can for you. Get every last extra return from your fixed income and make sure you’re not exposing yourself to undue risks. Lean more about the benefits and risks of XTBs.
¹ Term deposits may enjoy the benefit of protection under the Financial Claims Scheme.