Bond investors shouldn’t let the recent past derail their long-term investment strategy.
We’re over a month into this new financial year and it’s clear the economic hangover from 2022 is easing, but still lingering.
That is, the cocktail of persistent inflation, tight labour markets and rising policy interest rates remain in play.
But new financial years typically do herald new beginnings. Take fixed income, for example.
Although rising interest rates have created near-term pain for investors, higher interest rates and yields on bonds have raised return expectations significantly for fixed income.
As of June this year, Vanguard’s median annualised return expectations for Australian and global bonds ex-U.S (hedged to Australian dollars) over the next decade were 3.4% to 4.4%, and 3.6% to 4.6%, respectively.
Higher returns spur fixed income inflows
The expectations for higher bond returns are spurring strong investor inflows into fixed income exchange traded funds (ETFs) around the world, including in Australia.
Australian Securities Exchange (ASX) June data shows there were more than $2.4 billion of investor inflows into fixed income ETFs over the first half of this year, which included almost $1.9 billion of inflows into ETFs that invest in Australian government or corporate bonds and other fixed income securities.
There were more than $667 million of inflows into ASX-listed fixed income ETFs in the month of June alone, a figure that well exceeded the $299.6 million of investor inflows into Australian equity ETFs.
As at 30 June 2023 fixed income ETFs listed on the ASX were managing more than $17.6 billion of investors’ assets, which represented a 16.8% increase on the $15.1 billion of fixed income ETF assets being managed at the end of 2022.
By the end of the decade, we estimate current bond investors with sufficiently long investment horizons will be better off in wealth terms despite the recent fall in bond prices.
When interest rates rise, bonds reprice lower and cash flows can then be reinvested at higher rates. Over time, the increased income from higher coupon payments will offset the price decline, increasing an investor’s total return.
While 2022 was largely a horrible year for bonds, at the same time it was also an exceptional year for bonds – the perfect storm of high inflation and rising rates has improved returns expectations. As such, bond investors shouldn’t let the recent past derail their long-term investment strategy.
Three core benefits
Having weathered the surge in inflation and the subsequent tightening response from central banks, fixed income markets have experienced a greater degree of calm in 2023 and offer investors several core benefits.
First, based on data from 1994 until 2010 and their respective rate hike cycles, bonds have typically outperformed cash in the one- and three-year periods following the conclusion of hiking cycles. The first quarter of 2023 delivered the biggest quarterly return on Australian fixed rate bonds for over a decade. As noted, with yields having somewhat stabilised at higher levels, there are signs investors are seeking safety in defensive assets such as fixed income and cash ETFs in an effort to manage investment risks.
Second, fixed income continues to provide diversification benefits. Like insurance, the value of diversification has never gone away – but given the current economic and market uncertainty, expect it to be a key theme going forward. Investors should be looking at the traditional role of bonds in investment portfolios, which is to provide asset class diversification to help smooth out total investment returns over time. And whilst past performance is not a guarantee of future returns, historical data has shown how bonds can deliver income, capital returns and diversification benefits at a manageable cost to total portfolio returns.
Finally, bond markets are forward-looking and so expected changes to interest rates and inflation are already priced in. Vanguard’s economists expect Australia’s headline inflation rate to fall to around 4.5% by the end of 2023, as higher interest rates dampen demand, and to fall to the Reserve Bank of Australia’s target band of 2%–3% in late 2024 or 2025. Looking forward tends to be a better investment strategy than anchoring to the recent past.
The new financial year offers each of us a chance to look forward at financial goals, and the recent demand for bonds suggests fixed income is firmly back on investors’ radar screens.
An iteration of this article was published in The Australian Financial Review.
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Article courtesy of Vanguard.
