Riding the returns escalator explained

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Ask anyone in markets what the biggest driver of returns over the last decade has been, and they’ll probably tell you it was falling interest rates. As interest rates fall, the value of existing bonds rise. This effect is more pronounced the longer the maturity of the bond – hence the name, duration.

But despite popular perceptions, duration only accounts for a relatively small portion of bond returns. In reality, the majority of returns come from ‘carry and roll’. ‘Carry’ refers to the yield you receive on the bond once they mature,  while ‘roll’ is the appreciation in the price of the bond that occurs as the maturity date draws closer – the “escalator of returns”.

Hear Charlie Jamieson's deeper explanation in the video below. He also explains why now is the time to re-establish defensive positioning in portfolios.  


What are the biggest source of returns for bond investors in this environment? 

A lot of folks we talk to think they're investors, but they're actually speculators. So, we've got to kind of, again, put a time caveat on what is an investor. An investor, clearly, investing for much longer time horizons. And if you look at those longer time horizons, the most powerful driver of bond returns over the decade, from 2010 to 2020, was this thing called carry and roll. Now, very simply, carry is the yield that you receive on the bond when you buy them. If you buy them, put them in the bottom drawer and wait for them to mature, that is absolutely the income that you will receive. And if you hold that bond to maturity, it has a volatility of zero. It only is if you realise it that it starts to have volatility.

The roll is as you buy a longer dated bond in a positively-sloping term structure interest rate curve, this is what you all learned, 101 economic, macro-economics, first day of university, or whenever you might've done it or looked at it. If there's a positive sloping curve, and there is a really positive curve and there has been over the course of this year, as those longer bonds decay in maturity in time, they are rolling down the curve. And they're going to end up maturing at whatever day zero looks like. And at the moment, day zero, we have an RBA cash rate at 10 basis points, that is mechanically locked for a two and a half year period at the moment, was three years.

So that's a very powerful function. And essentially the bond has a capital appreciation or capital accretion in that process. So just to make the maths really, really easy, and these are not the current levels by the way, but let's assume that we have this lock at the three-year point at 10 basis points, and we buy a five-year bond at 50 basis points. As that five-year bond becomes a four-year bond, well, we know when it becomes a three-year bond, it will yield 10. And so when it's a five-year bond yielding 50, funnily enough, it's going to be pretty close to 30 as a four-year bond as it's sliding down. Now that curve isn't always perfectly linear in fact, very rarely. But that concept is essentially that kind of escalator of return, which is very implicit.

And that's what investors should be really focused on. For speculators, clearly duration gets all of the attention. It's the thing that's very obvious in the short term. Big duration moves generate big immediate price changes. And clearly if you realise then you can lock that in, be that positive or negative. We've seen that over the course of this year, big moves in duration, but that is the minority part of the return series. And that's really interesting because duration broadly has done quite well for a long time.

I think 999 out of 1000 people that were working in markets would tell you that the reason bonds generated 78.2% total returns last decade, "oh that's because duration rallied". Well, that's actually not the case. That was responsible for about 36% of the total return. And whereas carry and roll was by far and away the primary return driver. And we didn't start at materially high yields, by the way. So, we reckon that's a really important concept for folks that are building longer dated portfolios, retirement portfolios, super portfolios. When that curve gets steep, and when those longer dated yields rise, that is the best time to invest.

And that happened earlier this year, we wrote about that a lot in our inflation paper, we said that there's a very wide fire break to invest from that point on. And generally we looked at 12-month returns, well, the way that things have transpired is that the markets have rallied back really quickly. And so what was a kind of chaotic episode in terms of a sell off, which we didn't feel was justified, has rallied back almost as quickly. And we're kind of roughly back in balance, we think. Those opportunities when they do come along, they are not going to last very long. It our forever challenge, marketing defensive assets is to say, look, we appreciate that they haven't performed really well just lately, but if you are an investor, then these are really exciting times to re-establish.

And certainly for us and our business, a lot of folks said goodbye to us last year, which is perfectly rational. Equity markets had a huge drawdown, there was big demand for cash and liquidity. That's exactly what we do. Thanks very much guys, but we're off. And that's the way it's supposed to work. Clearly as equity markets have re-rallied off those lows around March and April and gone to the moon again, we did see a lot of folks starting to rebuild those defensive allocations. And that makes a lot of sense. In a world where everything seems to be expensive, bonds were actually relatively really cheap at the start of this year. And I fully appreciate after a 30-year bull market with some of the lowest recorded yields we've ever seen, in an absolute sense, that's a ridiculous thing to say, but in a relative sense, it's very, very true. They got a long way away from their cash rights. These curves got really steep.

For a while there, the Australian curve was as steep as it's been since 1992. I was in year eight in 1992 with pimples all over my face, being a kid, that was a long time ago. So these are extraordinary opportunities. When the curve gets that steep, you really do have to pay attention that in the go forward there is wonderful value that's been restored. And as we wrote about again, when you get these selloff episodes, what you'll tend to find is the market may not rally back as far as it actually came from. It might not go all the way back in terms of yields, but total returns can actually be higher than the total return of the selloff period. And that's really interesting. The bond maths, it's all laid out now in our inflation white paper, which no doubt folks can get a copy of pretty easily if they want to look into it, because the bond maths is really, really compelling around those types of issues.

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