Originally published by UBS Asset Management
Aussie bonds have been having a tough time of late. For a year now, we at UBS have been waiting for this moment, when all of the super-charged performance from mid-2016 started to drop out of the rolling 1-year returns. From May to August 2016, the Bloomberg AusBond Composite Bond Index returned +3.79% (absolute, not annualised!), as bonds powered higher by the Brexit vote, and the last cash rate cut from the Reserve Bank of Australia. Absent a global recession, it was always going to be the case that this stunning feat could not be repeated, and that there would be an apparent "slump" in bond market returns 12 months hence, as these events faded from the annual calculations. We are at that point right now.
The rolling 1-year return from Australian fixed income has recently turned negative, with the Bloomberg AusBond Composite Bond Index returning -0.66% for the 12 months to August 2017. Some in the media have asserted that these recent performance outcomes demonstrate that bonds are no longer fit for purpose, delivering negative (or zero) absolute returns to investors, as well as failing to provide traditional defensive properties in times of geopolitical turmoil. Such assertions could not be further from the truth, and fail to appreciate simple mathematics.
Chart 1 shows the monthly returns delivered from both the Bloomberg Barclays (LON:BARC) Australian Dollar Aggregate Index, as well as the more familiar Bloomberg AusBond Composite Bond Index. Both indices track each other very closely these days, but we have a little more granularity on the components of total return from the former Barclays index than for its AusBond counterpart. As can be seen from Chart 1, we have now dropped off the stellar monthly returns from Q2 and Q3 2016, but still retain some large draw-downs from Q4, in the aftermath of President Trump's election victory. The current 12-month returns for Australian bond indices now contain more of the "bad times" from the past year, and less of the "good times", but that is all about to change.
Just as we dropped off some very strong returns from the annual numbers in the past few months, so are we about to lose some of the heavy draw-downs from late 2016 in the next 3-4 months. Mathematically, this will return the rolling 12-month return from Australian bonds into positive territory, and we can posit some scenarios for the next 4 months to see just how powerful that swing back into the black will be. It is the darkest hour before the dawn right here and now; bond investors should not lose faith in the asset class just because returns over the past year have dropped below cash, or below zero per cent, on a temporary basis. Base effects can kick hard, but it is important to remember that they kick in both directions.
In Chart 2, we construct some simple scenarios for the possible path of Australian fixed income returns for the rest of 2017. The most basic outcome would be simply that the Australian bond market does nothing but return coupon income to investors, which has averaged around 34 basis points per month for the past 6 months (see Chart 1 above). That outcome would see the annual return swing from -0.66% to +3.83% by the end of 2017 (Scenario 1), as these positive income effects, plus the tail-wind base effects, substitute positive monthly returns for negative ones. If we assume that bond yields head modestly higher into year-end, we still get positive annual returns due to these base effects. Scenario 2 assumes that Australian bonds return zero per cent each month for the next 4 months (i.e. capital losses perfectly offset coupon income), while Scenario 3 sees a net draw-down each month, as bond yields rise by 10 basis points each month into year-end, and these price declines overwhelm coupon returns. In both of these scenarios, the annual index return will swing back into positive territory, falling somewhere between +1.65% and +2.50%, so at or better than cash by year-end. In Scenario 4, we see the effects of a modest bond market rally – a shift lower in yields by 10 basis points each month, for 4 months (the mirror opposite of Scenario 3). What makes Scenario 4 so much more powerful than the others is the combination of capital gains from higher bond prices, ongoing interest accrual of 34 basis points per month, and the favourable base effects of dropping off negative absolute returns from the end of 2016. If bond yields fell by 40 basis points between now and the end of the year, the annual return from Australian bonds could return towards +6.00%.
With markets already pricing in rate hikes from the RBA next year, it has been a rough ride for Australian bonds over the past couple of months: forgetting all of the good times and embracing the bad times. However, we retain the view that the RBA will be very cautious in its approach to policy normalisation, and will not blindly follow the likes of the Bank of Canada or the Bank of England in abruptly changing course. We remain overweight Australian duration in our Diversified Fixed Income and International Bond Funds, and we are positioned long Australian 10-year bonds against US 10-year Treasuries in our Australian Bond Fund. These are relative plays, of course, but in an absolute sense, we are about to see Australian bond returns stage a decent recovery. Don't lose faith: the sun rises in the east, and right now it is the darkest hour before the dawn.
