Fund managers are already on the scene and placing their bet

There have been recent disappointments but 2024 looks like ideal conditions for long-term bond investors and fund managers are already on the scene and placing their bets.

Bull and bear , symbolic beasts of market trend; investing generic

Australian government bond investors have been ravaged over the past two years with peak to trough losses in the range of 6 to 12 per cent. But it appears that the tide has turned and for the brave, there may be a window of opportunity to ride the bond wave and generate capital growth.

One thing is for sure, fund managers are already on the scene and placing their bets.

Government bond investments are known for regular income and capital stability. They typically form a core part of the defensive allocation in almost all investment portfolios whether that be in a SMSF, industry super fund or retail super fund. Safe, conservative and low risk are usually words associated with government bonds so recent losses have taken some by surprise.

The Australian government has approximately $900bn in debt however in this week’s Mid-Year Economic and Fiscal Outlook (MYEFO), federal treasurer Jim Chalmers announced that surging personal income and company tax receipts has reduced the 2023-2024 financial budget deficit from a projected $13.9bn to $1.1bn.

That said, the federal government will continue to raise billions of dollars to maintain its operations by issuing 1 year to 30 year bonds. The interest rate for each bond issuance depends on the RBA cash rate of the day and interest rate expectation over the period of the bond, in addition to other factors such as the bond term and credit rating.

In July 2020 when the RBA cash rate was 0.25 per cent, the Australian government issued a $19.6 billion 30 year bond paying 1.75 per cent interest maturing in 2051. The interest rate, known as the coupon, is fixed for the life of the bond and paid semi-annually.

Now here is the thing – If the Australian government issues another bond at a better interest rate, then the only thing that can change with the earlier bond is the price. As such, investors are willing to pay more for higher yielding bonds and less for lower yielding bonds.

And this is exactly what happened. The RBA cash rate is now 4.35 per cent and in the latest batch of Australian government bonds, the terms are a lot more attractive. In October the government issued a $8bn 20 year bond maturing in 2054 offering 4.75 per cent interest.

So what happened to the earlier bond from 2020 that was paying a measly 1.75 per cent interest? From an initial $100 issue price, the bond has fallen to a current price of $55. This is a 45 per cent paper loss in three years. But hey, you still get 1.75 per cent per year interest!

A cruel lesson for investors but this is a perfect example of how the bond market works in action. Investors have a constant choice and can buy existing bonds or buy into new bond issuances. As such, would you rather buy an existing bond that matures in 2054 that pays you 1.75 per cent annual interest or rather buy a new bond that matures in 2054 that pays you 4.75 per cent interest?

The answer is obvious and not only did investors prefer the new bond paying 4.75 per cent, they punished the 1.75 per cent bond by selling it down to a market price of $55.

The good news for the 1.75 per cent bond investor is that they will eventually get their $100 of capital back but they will have to wait until 2051, and on the assumption that the issuer is still around: in this case, it’s the Australian government, so it would seem likely. The price of the bond will gradually increase from $55 back towards $100 as the bond gets closer to maturity.

And as a side note, the credit rating of the bond issuer is a major consideration in what the bond yield will be. The Australian government with a AAA credit rating is viewed as almost a risk free investment given its extremely slim chances of default, however Argentina which has a CCC- credit rating, has defaulted on its bonds nine times since independence in 1818.

But back to today’s opportunity – cash rates are high and the consensus is that they are peaking and will start to fall late next year as inflation concerns dissipate. This opens up a window for bond investors to buy longer dated bonds. As the RBA cash rate starts to fall, you would expect the interest rate on future government bonds to also drop and as such, the price of existing bonds to rise.

Christopher Joye, chief investment officer at $10bn bond manager Coolabah Capital says:

“If and when central banks eventually come to cut interest rates, and long-term yields decline, fixed-rate bonds could deliver spectacular performance as their prices rise when yields fall.:”

“Coolabah has advocated averaging into fixed-rate duration since 2022, and I have lifted my own portfolio allocation to fixed-rate from 0 per cent to 25 per cent, which means I am 75 per cent floating-rate and 25 per cent fixed-rate, “ says Joye.

The thing with bond markets is that they are very efficient. They do not wait for the RBA to reduce interest rates before placing their trades. Bond markets move ahead of the RBA cash rate based on forecasts. As such, we have seen some long-term Australian government bond ETFs increase over 5 per cent in value over the last month alone.

Professional investors are adjusting their portfolios and overweighting longer term government bonds to ‘lock-in’ the strong yields they are currently offering which may not be seen again as cash rates start to drop.

For the individual investor, there are several Australian government bond ETFs to consider such as Vanguard Australian fixed interest index ETF (ASX: VAF). Betashares also launched a geared 10 year Australian government bond ETF (ASX: GGAB) this week. The gearing level is 250 to 300 per cent and is a clear way for investors to benefit from the potential of falling cash rates and rising bond prices but also with all the risks that gearing comes with.

Long term Australian government bonds are looking to close out 2023 strongly and may be an ongoing theme in 2024 assuming the market is right with the predictions of falling RBA cash rates later in the year

James Gerrard is principal and director of Sydney planning firm www.financialadvisor.com.au