Why the current rate conditions remain favourable for investing in bonds.
The Reserve Bank of Australia’s (RBA) latest decision to keep interest rates on hold at 4.35% affirmed the market’s view that, while higher rates are here to stay, they have likely reached the peak.
With every RBA decision, our attention tends to focus on the impact on borrowers. Higher rates have been a handbrake on households since the RBA’s increases began in 2022.
But for bond investors, there’s another side to the interest rate coin.
Investing in bonds effectively involves lending money to governments or corporates, so the calculus of higher rates is reversed.
In fact, higher rates can bring benefits to those seeking long-term diversification with high-quality bonds by offering a stable source of relatively low risk income.
Now that we’ve reached what appears to be the peak of interest rates, now is a great time to consider the benefits of bonds in your portfolio.
Bonds tend to outperform after rates hit their peak
The RBA’s inflation battle is far from over, but we’re confident it will be won.
In Vanguard’s view, a sticking point remains with elevated unit labour costs, which are making it harder for the RBA to hit its 2%–3% inflation target.
We see a constrained supply side that’s still affected by soft productivity growth, meaning a sustained period of weak demand will be needed to bring inflation down to target.
As a result, we expect the RBA to be one of the last developed markets central banks to cut its policy rate—which we don’t foresee happening until 2025.
However, while there may be flexibility around the timing of rate cuts, we believe we’re at or near the end of the rate hiking cycle, which has historically been associated with a peak in yields.
This is good news for bonds, which have typically performed strongly in the years following the peak.
Waiting for the ‘right’ moment to review your bond exposure may mean missing out on a price boost when rate cuts do eventually happen.
What happens when rate hikes end?
Annualised performance following the rate hike cycle.
Notes:
1994 rate hiking cycle, which commenced July 1994 to first Tuesday of December 1994, so 30 November is used as a start date for 1994.
1998-2008 rate hiking cycle, which commenced October 1999 to first Tuesday of March 2008, so 29 Feb 2008 used as start date for 1998-2008 hiking cycle.
2009 rate hiking cycle, which commenced September 2009 to first Tuesday of November 2010, so 31 October 2010 used as a start date for 2009 hiking cycle.
Source: Vanguard and Bloomberg
Past performance information is given for illustrative purposes only and should not be relied upon as, and is not, an indication of future performance. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
For those entering the bond market now, this means there’s an opportunity to enjoy historically higher yields while potentially benefitting from short-term price tailwinds if rates do moderate.
Given that bonds have only recently emerged from a tumultuous period of rapidly rising rates, it’s understandable that investors are cautious.
Many may be waiting for the RBA and other central banks to finish hiking—or even begin cutting—before they jump back into bonds.
Waiting for the ‘right’ moment to review your bond exposure may mean missing out on a price boost when rate cuts do eventually happen. Moreover, it could mean missing out on the rate peak and enjoying higher yields.
What if interest rates stay high?
Even when rates do move lower, we don’t foresee a return to pre-COVID levels when interest rates were near zero. In short, higher rates are here to stay.
We’ve spoken at length this year about the return to sound money and why higher, positive real interest rates may be the single most important development in financial markets in the past two decades.
This situation isn’t unique to Australia. According to Vanguard’s research, the neutral (or equilibrium) rate has increased by around 1% on average across developed markets, mainly driven by aging demographics and higher structural fiscal deficits.
While higher-for-longer rates might be painful for borrowers, they’re a good thing for investors over the long run, particularly for bond investors.
In fact, we expect investors to be better off because of (not in spite of) higher rates.
As the chart below shows, bond prices were pushed down by rising rates in 2021 and 2022. However, higher yields and coupon payments make up for short-term principal losses over time.
That’s why we now expect bond investors who remain invested to be better off in end-of-period wealth terms by the end of the decade.
End-of-period wealth for bond investors is expected to be higher
Important: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of 31 December 2021, and 31 March 2024. Results from the model may vary with each use and over time. For more information, please see the “Important information” section.
Notes: The chart shows actual returns for the Bloomberg Australian Aggregate Bond Index along with Vanguard’s forecast for cumulative returns over the subsequent 10 years as of 31 December 2021, and 31 March 2024. The dashed lines represent the 10th and 90th percentiles of the forecasted distribution. Data as of 31 March 2024.
Sources: Vanguard calculations, using 31 March 2024, VCMM simulations and data from Bloomberg.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
This doesn’t mean that investors won’t potentially realise losses in the short term as yields move around, or that they’re guaranteed profits in the long term. But when assessing the impact of higher yields, your time horizon as an investor matters a lot.
Investors are returning to bonds
If we take a look at exchange traded fund (ETF) flows, it’s clear that investors are cautiously returning to the bond market. In 2023, strong renewed interest in bond ETFs saw fixed income flows reach almost 45% of total market flows.
Australian bond ETFs received $3.81 billion in cash flows in 2023, a 37% improvement year on year. Global bond ETFs also attracted $1.5 billion over the year, up 99% year on year.
This momentum continued with a further $1.5 billion added across Australian and global bond ETFs in the first half of 2024.
We anticipate bond ETFs will remain popular with Australian investors throughout the remainder of 2024 and beyond, particularly as our domestic bond return expectations have substantially increased since 2022 from 1.3%–2.3% to 4.1%–5.1% over the next 10 years.
Similarly, for global bonds, we expect annualised returns of 4.4%–5.4% over the next decade, compared with a forecast of 1.6%–2.6% when policy rates were low or, in some cases, negative.
With higher yields, the benefit to long-term investors of being invested in bonds should outweigh the cost of being a little early should yields remain flat or even edge up slightly before the rate cuts hit.
Timing the market is often harder than we think, and getting timing decisions wrong can mean limiting your returns in the long run.
For most investors, a prudent asset allocation that includes both equities and bonds, matched with a long-term investment plan, may present a better chance for investment success.
Feel free to contact our investment team to find out how we can help you reach your financial goals. Give us a call at 08 8231 4709 or send us an email at info@centrawealth.com.au.
Article courtesy of Vanguard.
