Originally published by UBS Asset Management
A year ago, Bill Gross tweeted that the bond market was "a supernova that will explode one day". That was on the 9th June 2016, just before the UK's historic referendum on European Union membership. The really interesting factoid is that global bond yields troughed about a month after Bill's tweet, and then rose by around 70 basis points between July 2016 and March 2017 (Chart 1).
CHART 1
Source: UBS; Barclays (LON:BARC); Bloomberg. Data represent the Yield to Worst on the Bloomberg Barclays Global Aggregate Index, up to 31 May 2017.
Did that devastate the bond market, exploding investors' safe have assets like a supernova? Not by our reckoning! The annual return on the Bloomberg Barclays Global Aggregate Index (hedged to AUD) was 2.68% for the year-ending May 2017, whereas the gross return on our UBS International Bond Fund – an active global bond portfolio that follows the Global Aggregate benchmark – was even better than this, at 2.82%. The one year performance outcome for our UBS Diversified Fixed Income Fund (DFIF) was better again, at 3.15% before fees. By comparison, the return on Australian cash (using the Bank Bill Index as a reference point) was just 1.84%. How was this outcome possible, when global bond yields rose, and duration remained at a record high of around seven years? What happened to that supernova?
The answer remains exactly the same as we discussed in our white paper last year: price returns are just a part of the total return outcome. As shown below, price returns were negative for global fixed income over the past 12 months, as bond yields in all major markets – except the UK – rose. In purely capital terms, a global bond portfolio lost around 1.33% of its value, due to this rise in bond yields. However, the total return on a bond portfolio represent the sum of both capital and income returns, and the income cushion provided by global coupons (2.53% p.a.) and the forward FX points (1.62% p.a.) was more than sufficient to offset the mark-to-market losses from higher bond yields. Total returns remained positive on an annual basis, and the final outcome for the Global Aggregate Index over past 12 months was essentially represented by the coupon payments (Chart 2). That is not a bad outcome from a bond portfolio: capital growth is always welcome, but there is a reason that our asset class is called "fixed income".
CHART 2
Source: UBS; Barclays; Bloomberg. Data as at 31 May 2017.
The monthly pattern of global fixed income returns has been volatile, as bond markets reacted initially to the shock of Brexit, but then suffered under the reflation trade in the aftermath of President Trump's election in November. What has been consistent, however, has been the income stream that has been generated from both coupons and hedging out the AUD exchange rate risk (Chart 3).
CHART 3
Source: UBS; Barclays; Bloomberg. Data as at 31 May 2017.
These income sources have generated around 0.35% per month in absolute return, with movements in bond yields being the swing factor each month in determining whether bonds were up or down as an asset class. Abstracting from this monthly volatility, we saw above in Chart 2 that the cumulative effect of these stable monthly income returns generated a cushion of over 4% in absolute returns, a cushion that was more than sufficient to absorb the drag from the bond market sell-off in Q4 of 2016. This outcome has reiterated our core thesis from last year's white paper that fixed income returns are more than just a duration play, and that income sources should certainly not be ignored as important drivers of total returns for the asset class.
Diversification across markets has also been an important theme over the past year. Not all markets have moved with the same beta, and the "losers" from the Brexit and Trump revolutions may not be as obvious as one might have suspected. The worst performing markets within the Global Aggregate Index, from a purely capital perspective, were Mexico and South Korea. In our Diversified Fixed Income Fund, we have held no exposure to either market during the past 12 months. Those most insulated during this tumultuous time have been markets with shorter duration, and with higher coupon streams. Markets such as Australia and New Zealand have stood out in this respect, and we have been positioned long in both markets over that time period. Again, the value of active management has come to the fore, with UBS portfolio managers seeking out markets that remain attractive, and steering away from those that present risks to our clients.
Going forward, we have probably seen the low point for global bond yields, and the task for investors will be to navigate the new environment. With the US Federal Reserve raising the Fed Funds rate, and the RBA seemingly on perma-hold, there is a clear likelihood of US interest rates rising about Australian interest rates in the foreseeable future. This will erode the immediate income benefits of hedging global bonds, but will eventually improve the prospective coupon returns from investing offshore. Europe and Japan will provide occasional swing factors, as aggressive central bank intervention in both bond markets eventually slows. A regime change is still some way off, but it is closer on the horizon than it has been for many years. We have successfully eluded Mr Gross' supernova moment over the past year, and as long as we still see sufficient income compensation for the duration risks, that moment of reckoning is still some way away. Watch the heavens, by all means, but don't let the supernova talk blind you to the income returns that are available each and every month.