Ask a Fund Manager
The Motley Fool chats with fund managers so that you can get an insight into how the professionals think. In part 2 of this edition, we're rejoined by Yarra Capital Management's fixed income specialists, Darren Langer, co-head of Australian fixed income, and Chris Rands, co-portfolio manager of the Yarra Australian Bond Fund. Today they discuss the outlook for bond markets amid high interest rate expectations.
The Motley Fool: Yesterday we discussed the aggressive pace and level of interest rate rises flagged by the US Fed and the RBA. How has a rising rate environment impacted the returns of the Yarra Australian Bond Fund?
Darren Langer: We run a fixed rate fund, and it's very sensitive to higher rates. Bond returns are the worst they've been since the 1980s. And it's been quite horrific for the average bond holder who expects to get positive returns most of the time. This is the once in 20 to 30-year event when you get bond returns that are negative.
The only other time we've had negative bond returns in the last 30 years was in 1994, and not quite as negative as what they are at the moment. But we expect that negative return to dissipate as markets start to price in a more sensible rate hike cycle. At the moment, they're still pricing in very aggressive rate hikes. So some of that may come off.
But, clearly, it's been a difficult year for bond investors. Anyone in fixed income markets that's had floating rate funds are probably doing relatively OK. They probably haven't seen the negative returns. And they're probably getting higher cash yields than what they have been.
MF: So it's been a tough year not only for share investors but fixed income as well. What's your outlook going forward?
Chris Rands: When you're looking forward, the yield to maturity that you buy the bond at is going to be your best kind of forecast if you hold the bond to maturity. Because rates have moved so far, if you think of a three-year bond with a 4% to 4.5% yield, if you hold onto that for the three years to maturity you get a 4%, 4.5% return.
In the past 10 years, it's been difficult to get that kind of income. Now, if rates keep rising in the short term, you can get that sort of 4.5% return. So the outlook is much healthier now, after the adjustment in bond yields, than in the past 24 months.
DL: Generally, the one year you have a sort of awful outcome in fixed rate bonds, the next couple of years are reasonably positive. You don't get really high returns in fixed income, but you'll be more likely to see those 3% to 4% sort of returns rather than the half to zero we've seen over the last 12 months.
With rates going higher this last year, it's been quite negative. But for new investors coming in, they'll probably see a much better outcome.
MF: Are you adjusting your investment strategies in the primary and secondary bond markets with higher rates in mind?
CR: We're a long-only bond manager, so we're going to be looking at the market regardless. In terms of our positioning, the best way to think about yields is the spread to cash.
If you look at the three-year bond, for example, it will typically sit about 50 basis points over cash. When the cash rate is zero, the three-year bond is probably about 0.5%. And if, somehow, the RBA was able to get the cash rate to 5%, the three-year bond rate would be above 5%.
From our strategy, we're really trying to base our decisions on where we think the cash rate is in the future. If you think the RBA will only get to a cash rate of 2%, then you probably should be out there looking to add bonds.
As long as we believe we can forecast the RBA, we should be thinking about how we position around where the cash rate eventually ends.
DL: The one thing that's been positive for fixed income investors is we've gone past the interference in the markets, which has basically dragged spreads in quite tightly. The credit margin that companies have to pay above the risk-free rate got very tight, because the RBA was buying bonds, and that drags everything down with it.
Now a lot of that's gone out. New issuers coming to the market are actually paying a higher spread to borrow, a higher premium than they were six to 12 months ago. That's one area where we've been able to pick up some good investments. There are companies coming to market with a much fairer return to investors.
As new primary issuance comes to market at higher spreads, this re-prices the secondary market and gives us the opportunity to pick up assets at better levels than we could have over the last six months or so.
MF: Should investors be concerned over the potential for rising corporate bad debts?
DL: In Australia, we think corporates are in a pretty good place. Most of them have pretty strong balance sheets. We haven't seen the excess build-up in debt in the Australian market that you've had in some offshore markets, like the US.
We also tend to have a more investment-grade market, with higher-rated corporates that borrow in this market.
Where there are problems that might show up is more in the sub-investment grade, think below BBB- ratings. But Australia doesn't have a large sub-investment grade market, so a lot of those problems are more likely to come offshore. And more so if they keep jacking interest rates higher and higher.
CR: If you think about that from the macro perspective, Australia seems to always land in this very fortunate position, where we really are the lucky country.
It looks like the world is starting to slow down, and yet commodity prices, while they have come off, are still sticking very high. So, if you're starting to think about recession, not only do we look a little better than offshore, but also the RBA is not going as aggressive as those other central banks.
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Tune in tomorrow for part three of our interview, where Yarra Capital's Darren Langer and Chris Rands discuss the threats and opportunities for bond investors in the year ahead. If you missed part one, you can find that here.
(You can find out more about the Yarra Australian Bond Fund here.)
