Key things to understand about bonds in a COVID-19 impacted world

by Nathan Boon & Sonia Baillie

Bonds have been strong performers over more than a decade in the lead-up to the current crisis1, and we believe they could play an important part in defensively positioned portfolios going forward. Their popularity is affected to a certain extent by a lack of understanding on the part of investors, relative to equities, but the principles are really quite simple. Here are a few things we bear in mind when considering a role for bonds in a portfolio:

1. Income = defensive positioning

An important part of building a defensive position into a portfolio is the inclusion of securities with cash flows that are resistant to market downturns. Taking into account the credit risk of the issuer, bonds can offer an opportunity to harvest regular and reliable income streams with lower risk of capital instability.

2. Bond returns are typically driven by interest rate sensitivity

As interest rates fall, the discount factor used to value the income streams they generate is reduced, increasing the value of those cash streams today. The yield on issued bonds becomes more attractive, driving up prices and returns.

The sensitivity of a fixed income security’s price to changes in yield increases the further a bond is from its maturity. When measuring how sensitive a bond’s price is to changes in interest rates, we refer to its duration, a term which refers to the amount of time it will take for the bond’s principal to be repaid to the investor. The higher the duration, the more interest rate sensitivity is embedded in the security.

The strong performance of bond markets over the past decade has been mostly due to a falling interest rate environment, fuelled by a series of financial crises and the lack of ability on the part of most major economies to generate significant inflation, in turn necessitating monetary stimulus in the form of lower interest rates. In this environment, portfolios with higher duration have tended to perform strongest.

The gains on offer from interest rate risk have plateaued in recent years as interest rates across most of the developed world have effectively bottomed out, and it’s important for investors holding these assets to understand the specific role they play in their portfolio structure.

3. Investment grade credit can play a defensive income role

Credit spreads are the difference between yields on corporate bonds and government bonds, and represent the additional credit risk premium allocated to the issuer of the bond. They are negatively associated with pricing, as they imply a lower return relative to the risk-free rate.

Credit spreads widened dramatically during the first stages of COVID-19, as passive bond funds underwent forced selling and introduced excess liquidity into the market. Over the past few months, however, spreads have largely stabilised towards pre-COVID levels, particularly in investment-grade bonds.

Despite this, investment-grade credit spreads tend to have a fairly low volatility, and well-constructed portfolios may provide access to this credit risk premium for a low level of downside risk. We find that through the cycle, investors in Australian investment-grade tend to be overcompensated for the credit risk they are taking. By investing into a diversified portfolio of stable investment-grade bond issuers, investors may earn superior risk-adjusted returns, and do so without seeing undue volatility in the total returns they earn from these investments. In an environment of very low yields globally and where investors are being tempted down the quality spectrum to earn moderate returns, we view this as a key means of earning defensively-oriented income in an uncertain environment.

4. The outlook for Australian investment grade bonds remains positive

Australian companies were, as a whole, better prepared for this crisis than their counterparts in countries such as the US. We believe Australian corporates entered the recession with stronger and much more conservatively positioned balance sheets2, and were very quick to raise equity where they faced uncertainty. This supportive attitude to creditors has been reflected in ratings, and our corporate sector has for the most part avoided the ballooning leverage witnessed in other markets.

That said, there are still considerable downside risks ahead relating to the future evolution of the pandemic and the capacity for our economy to recover within that constraint. We consider that uncertainty is likely to persist for some time, especially with the risk of further waves and lockdown.

Despite this potential volatility, we believe inflation and interest rates are likely to remain low in the short to medium term, and future stimulus programs should remain highly supportive of credit markets. Because of this we hold a positive outlook for Australian investment-grade credit, and view a well-constructed portfolio of defensive income in this space as being a critical component for weathering what is likely to continue to be an uncertain economic environment for some time to come.

 

Bloomberg
Bank of International Settlements (BIS), AMP Capital


Author: Nathan Boon, Head of credit portfolio management | Co-portfolio manager AMP Capital Sydney, Australia

Source: AMP Capital 13 Oct 2020

Reproduced with the permission of the AMP Capital. This article was originally published at AMP Capital

 
Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.