We need a bond market revolution

Christopher Joye

Coolabah Capital

In The Australian Financial Review I argue that we need a revolution in bond market investing that discards the entirely spurious indices most institutions benchmark against and even more importantly acknowledges that most bond exposures are loaded up with massive amounts of speculative interest rate risk that have absolutely nothing to do with the income and capital structure security that rationalises this asset-class as a defensive investment (click on that link to read the column for free via Twitter). Excerpt below:

"Let's go back to first principles and consider why we allocate money to so-called fixed-income. The main motivate is to enhance the certainty of our returns by moving up the corporate capital structure and reducing the risk of loss...In Australia, shares have furnished a 5 per cent excess return above the risk-free rate since the second world war. Yet that comes with tremendous uncertainty (or 15 per cent annual volatility)---the 50 per cent capital losses during the global financial crisis were the latest reminder of this threat. If you are chasing returns north of 8 per cent, equities are the place to be. If, on the other hand, you have more modest income goals—say 3 per cent to 4 per cent above inflation (or 6 per cent in total)—then a deposit or floating-rate bond that pays a 1 per cent return over cash would have historically met your targets with a fraction of the equity market's risk. When we invest in cash and bonds we often don't just take a capital structure exposure: many of these investments also bundle together a massive speculative bet on the future direction of rates that nobody can have any realistic hope of getting right. When you take out a mortgage to buy a home, you intuitively understand that your lowest risk, or most passive decision is to use a variable-rate loan. Repayments just rise and fall with the cash rate. If you want to gamble a little, you can fix the repayments on the loan for up to 5 years. You lose if rates fall and win if they rise. The same logic applies to cash and bonds. A variable-rate deposit does not second-guess interest rate variations. But punt on a 5-year fixed-rate term deposit and you are rolling the dice. If the cash rate increases you will be worse off because you fixed your interest at an inferior rate. In the bond market the interest rate neutral, or passive position, can only be obtained through floating-rate instruments, which provide a pure exposure to the capital structure certainty you wanted. Sophisticated investors can also buy fixed-rate bonds and hedge out their interest rate risk. The concern is that most fixed-income money in Australia is benchmarked against the AusBond Composite Bond Index, which only includes fixed- as opposed to floating-rate debt securities. To make matters worse, these fixed-rate bonds are not short-term: the typical term is 5 years. This means that rather than getting a highly secure or defensive investment, you are conflating a huge bet on the macroeconomy with capital structure certainty (it's like punting all your money on 5-year term deposits that suffer when rates rise). All the research shows that nobody can predict interest rate changes with consistent accuracy more than 6 months ahead, let alone 5 years out. The RBA itself admits it has no clue where economic growth will be 12-months ahead. To quantify this risk, a AAA rated, fixed-rate Australian government bond with a 5-year maturity, which is ostensibly risk-free, would incur a 4.4 per cent capital loss if the (maturity-matched) cash rate increases only 1 per cent. In the December quarter the superficially conservative Composite Bond Index lost 3 per cent of its value precisely because medium-term cash rates appreciated on the back of superior global growth prospects. If this index hedged out these rate bets it would indeed be defensive. This is borne out by the fact that the AusBond Floating-Rate Note Index's long-term volatility is one-sixth its Composite Bond counterpart. Some think they want interest rate "duration" because it's a hedge against poor equity performance. Yet Milliman have demonstrated that over the last 125 years the correlation between fixed-rate bonds and Aussie equities is positive, not negative. And in a climbing rate environment this is especially likely to be the case (fixed-rate bonds will fall in value while floating-rate debt thrives). The second problem is the Composite Bond Index's construction. Unlike the All Ordinaries Index, it does not weight issuers by market capitalisation---it weights individual bonds (not issuers) by their size, which can be very different to the entity's worth. And it is not representative of the debt market. About 90 per cent of the index is in government bonds with only a 10 per cent weight to corporates. Yet Deutsche Bank says government bonds only make up 46 per cent of the investment-grade asset-class (and much less if you include unrated debt). Smart investors understand these dangers. The Future Fund has no interest rate risk in its bond portfolio, hedging it all out. A separate strategy team then independently puts on interest rate bets, assuming they want any. The bottom line is that a truly passive bond portfolio should float, rather than fix, its interest." 


Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 26 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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