Investing

A tale of two curves: Why there is value in 3 year bonds

  • 13.DEC.2016
  • Ian Martin,  XTB

The key reasons why people invest in fixed income can be defined as:

  1. Purchase a defensive asset that has a low or negative correlation to risky assets;
  2. Gain exposure to duration or to the change in price from a change in interest rates;
  3. Obtain certainty of outcome, which is possible by holding to maturity. Therefore, it is easier to achieve certainty with shorter dated bonds or XTBs than with longer dated bonds.

 

The analysis below aims to provide a simple model for valuation. In doing so the assumptions are basic and over simplified, they could be refined in a longer study of the subject.

The US 10 year market

In the US the market is repricing the economic impact of the new administration.

  • The US 10 year government treasury bond (UST 10s) has a yield to maturity (YTM) of 2.47% as at close in New York on 9 Dec 2016;
  • The Australian 10 year government bond (AUS 10s) has a YTM of 2.87% or 0.40% more than the UST 10s (0.40% = 2.87%- 2.47%);
  • For this analysis, we will assume the AUS 10s will track the UST 10s 1 for 1 (my first assumption).

It is quite possible that the US 10s may move higher in yield.

  • Secondly, I will assume the UST 10s move to 3.00% or 0.53% higher in yield;
  • Based on my first assumption this would mean the AUS 10s move to 3.40% which is 0.53% higher than their current YTM.

But what about value in 3 year bonds?

My third assumption is that the pricing of Australian 3 year government bond (AUS 3s) is a function of:

  • The difference between the RBA rate (Currently 1.50%) and the AUS 3s YTM; and
  • The difference between the RBA rate and the AUS 10s YTM.

 

Chart 1 shows the purple line which is actual YTM of government bonds at different maturities. This is called a yield curve.  The green line is a simple linear interpolation between the RBA rate vs AUS 10yrs. Please note bond academics would never use such a simplistic method for valuation, but it gives us a guide.

Chart 1: Yield curve scenario: 0-10 Years

Yield curve scenarios 0-10 years

Source: Bloomberg and Australian Corporate Bond Company

What about the RBA?

The current market pricing assumes there is a small possibility of a cut by the RBA during 2017.

Chart 2: Market price of RBA movements in 2017

Market price of RBA movements in 2016

Source: Bloomberg

Therefore, I make a fourth assumption that the RBA is on hold for 12 months.

What happens to AUS 3s if AUS 10s move and RBA is on hold?

Using the RBA on hold assumption, I create a new synthetic yield curve 2 assuming:

  • The RBA is on hold;
  • UST 10s move to 3.0%; and
  • AUS 10s move to 3.40%.

In chart 3 the grey line or synthetic curve 2 represents this new yield curve. Chart 4 is the same data but simply out to 3 years to show the magnitude of the movement.

CHART 3 & 4: Yield Curve Scenarios 0-10 years and 0-3 years

Yield Curve Scenarios 0-10 and 0-3 years

Source: Bloomberg and Australian Corporate Bond Company

The data in Table 1 shows that the 3 year YTM could move to 2.03 % (a 0.20% change) even though AUS 10s have moved by 0.53%

This would create a yield curve of 0.53% between AUS 3s and the RBA.
Yield curve = AUS 3s – RBA. 0.53% = 2.03% – 1.50%

MATURITY YTM % SYNTHETIC CURVE 1 SYNTHETIC CURVE 2
10 DEC 16 1.50 1.50 1.50
21 JAN 18 1.71 1.65 1.70
21 OCT 18 1.79 1.75 1.84
21 OCT 19 1.93 1.88 2.03
22 NOV 20 2.09 2.02 2.23
15 JUL 22 2.32 2.24 2.53
21 APR 23 2.49 2.34 2.67
21 APR 24 2.66 2.48 2.85
21 APR 25 2.78 2.61 3.04
21 APR 26 2.82 2.74 3.22
21 APR 27 2.87 2.87 3.40

The benefit of carry

As the AUS 3s get closer to maturity they will also get closer to the RBA rate of 1.50%. If nothing changes your 3 year investment does not change and you have captured the carry in favour of a higher YTM.

Investors would have been rewarded for investing in a 3 year bond instead of holding a shorter dated investment.

So how steep has the curve between RBA and AUS 3s been?

The top half of chart 5 plots the generic AUS 3s and the RBA rate.

  • Since 2011 the curve has not been steeper than 0.66%
  • In 2009 it touched 2.09% when the market was expecting the RBA to remove the 4.25% emergency easing during the GFC. In fact the RBA raised rates by 1.75% from 3% back to 4.75%

The bottom chart is the spread between the RBA rate and AUS 3s. The same data but expressed as a spread.

Chart 5: RBA vs AUS 3s

RBA vs Aus 3 year bonds 2016

A tale of 2 yield curves:  How to invest even though rates may rise

The AUS 10s and longer dated bonds have plenty of scope for movement.

The AUS 3s however can be seen as having value while the RBA rate is priced to be on hold. This is why commentators are discussing investing in shorter dated bonds rather than longer dated bonds.

Individual bonds and XTBs provide a solution

  • A common form of investment is in funds that benchmark themselves to the Bloomberg AusBond Composite Index (The Index).
  • However, the index covers bonds with maturities from 1 to 30 years.
  • By investing in individual bonds or XTBs, investors can select the maturity profile to suit their needs and views of the market.
  • Corporate bonds and XTBs also offer higher returns to reward investors for investing in companies rather than the government. For instance, YTMCCA (Coca Cola Amatil) matures in Nov 2019 and has a YTM of 2.803% while YTMAWC (Alumina) also maturing in Nov 2019 has a YTM of 5.22%

 

Call us to discuss this article and how it affects your investment portfolio.

T: 1800 995 993
E: advisers@xtbs.com.au

This article first appeared in Yield matters on 13 December 2016.

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