Understanding index returns

  • 04.Jul.2016
  • Ian Martin,  XTB

Falling interest rates: Good for fixed income

It has proved to be another good year for fixed income.

Australia has seen interest rates fall as we join the rest of the world in a lower for longer rate environment. Chart 1 shows the yield curve for Australian government bonds now (the green line) and 1 year ago (the grey line).

Chart 1: Australian government bond yield curve

Australian government bond yield curve July 2016

Source: Bloomberg

Bond indices and their returns

The Bloomberg AusBond composite index (composite index) returned 7.02% for the financial year (FY).

The composite index is a widely used benchmark for fixed income in Australia. The index is made up of bonds issued by the Commonwealth Government, individual states, supranational institutions (like the World Bank), and corporates.

Corporates only account for approximately 12% of the index.

Each type of bond has their own index.  The Bloomberg AusBond index family tree below shows the constituent parts.

The Bloomberg AusBond credit index returned 5.34% for the FY. Reference bonds for fixed rate XTBs are selected from the credit index.

Chart 2: The Bloomberg AusBond index family tree

Australian Bond index family tree

Source: Bloomberg

Comparing returns

When comparing the returns of the composite and credit indices it is worth digging deeper to appreciate why they differ.

An obvious difference is the issuers. The composite index has 87% government and government-like issuers. In the credit index the issuers are companies (which includes banks).

Another major difference is the amount the price of each bond moves when its Yield To Maturity (YTM) changes. The longer a bond’s maturity the more sensitive is it’s price is to change in YTM.

Average life

The composite bond index has an average life of 5.73 years and the credit index has an average life of 3.68 years. Therefore, in a falling interest rate environment you would expect a portfolio with a longer average life to outperform a portfolio with shorter average life.

Table 1: Average life of bond indices

Average Life
Composite Bond Index 5.73
Credit Index 3.68
Source: Bloomberg

But how did corporates do on a like for like basis?

Fortunately Bloomberg also gives us sub-indices by maturity so we can compare groups of bonds or indices with similar average lives. Table 2 gives a sample of indices by their maturity profile.

Table 2: Average life of sub-bond indices

All Maturities 0 -1 Year 1-3 Years 3-5 Years 5-7 Years 7-10 Years 10+ Years
Composite Bond Index 5.73 0.54 1.89 3.90 6.05 8.56 13.71
Credit Index 3.68 0.52 1.98 3.83 5.81 8.29 9.98
Source: Bloomberg

There are not as many longer dated corporate bonds as government bonds so the average life of 10+ years is significantly different between the two indices.

If we compare the return of each sub index we get a greater understanding of the effect the average life has on each index performance.

Table 3: Return of sub-indices by maturity buckets – Return for one year

All Maturities 0 -1 Year 1-3 Years 3-5 Years 5-7 Years 7-10 Years 10+ Years
Composite Bond Index 7.02% 2.34% 2.94% 4.94% 7.56% 10.83% 15.71%
Credit Index 5.34% 2.88% 3.41% 5.15% 8.22% 10.76% 14.81%
Excess Return of Corporate Bonds -1.68% 0.54% 0.47% 0.21% 0.66% -0.07% -0.90%

The longer an index’s average life the better it performed over this FY.

For maturities between 0 to 7 years corporate bond indices actually outperformed the composite index equivalents.

For the indices beyond 7 years the composite Indexes have a longer average life than there credit equivalents.

Credit performance

When comparing a corporate bond against another corporate bond, an index or even government bonds, the change in credit spread will also affect the total return. This is easier to describe when looking at individual bonds and XTBs. I will address this issue in a later edition of Yield matters.

Why is this important?

Bonds and XTBs are often held as a buy and hold investment in which case the final return will be approximately the YTM you purchased the bond for.

If an investor however wishes to rotate out of an XTB because they either need the funds elsewhere or think there is value in a different asset class, they will be sensitive to the mark to market.

One of the many benefits of XTBs is you can trade them on the ASX and receive funds in two business days.

How to build a fixed income portfolio

By selecting XTBs an investor can create a portfolio with their own specific maturity requirements in mind.

We have built a series of tools that help investors choose from the available 39 XTBs and create the right portfolio for them.

These tools include:


Coming Soon: Model portfolios from ACBC will shortly be available to further help you create the right portfolio of XTBs to meet your client’s requirements. View available models from Ord Minett and BondAdviser.

A note on average life

When we analyse the interest rate exposure of a bond we actually use modified duration as a tool rather than average life. Modified duration has some characteristics of average life but also uses the time value of money.

Regardless, we know that average life is a common concept and helps introduce investors to the concept of sensitivity to changes in YTM.

Author: Ian Martin, CIO and Co-Founder Australian Corporate Bond Company.
This article appeared in Yield matters on 5 July 2016


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