Bond portfolios could still be on track to generate positive returns in the years ahead, according to Zenith Investment Partners, despite ongoing interest rate hikes from global central banks.
In a recent note, Zenith’s head of multi-asset and fixed income, Andrew Yap, acknowledged that this outlook may seem counterintuitive, but he argued that the performance of bond markets is determined by the market’s anticipation of future rate rises rather than central banks’ actions.
Accordingly, Mr Yap suggested that official cash rates in Australia, as well as those in the US, the UK, and Europe, are likely nearing the market’s forecast of the peak in the current cycle.
“Should inflation surprise on the upside, this may extend the current interest rate hiking cycle. That said, the yield on offer across developed market sovereign bonds is sufficiently high to offer a cushion to offset capital losses on any subsequent bond repricing,” he said.
“Retaining an overweight to bonds may translate into outsized returns as central banks loosen policy to stimulate growth. Active management may prove to be rewarding in the years ahead, and managers with a proven track record in interest rate management are positioned to outperform.”
While an unexpected rate hike would put downward pressure on bond prices, Mr Yap argued that interest rates would have to rise significantly higher than currently expected before the capital losses overtake the income generated from bonds.
Based on data as of 31 March, Zenith reported that the market was pricing in a peak of 3.62 per cent for Australia to be reached in May, compared to the current cash rate of 3.60 per cent.
“Interest rates in Australia would need to rise a further 0.35 per cent above the market’s implied peak cash rate before the 3.30 per cent yield to maturity is fully offset,” Mr Yap said.
“While such an outcome is not outside the realms of possibility, it’s a lower probability event and as such, sovereign bond holders have a reasonable level of insulation against unexpected hikes in the official cash rate.”
Australian economists are currently split on the future movement of interest rates locally.
Some, including CBA’s head of economics Gareth Aird and HSBC Australia chief economist Paul Bloxham, believe that the cash rate may have already peaked locally, while others, including economists at ANZ, expect that at least one more rate hike is in store.
Looking at the yield curves of 10-year Treasury bonds issued in Australia, the US, the UK, and Europe, which take into consideration near-term expectations, inflation, and real long-term growth rates, Mr Yap determined that the market is pricing in further hikes to combat inflation.
“In the case of the US, markets are anticipating that the Fed will raise interest rates to 4.98 per cent by May 2023, up from its current level of 4.88 per cent (being the midpoint of its 4.75 to 5.00 percent),” he said.
“Should subsequent increases in this rate remain within this range, it’s unlikely that the 10-year sovereign bond yields will significantly shift.”
Jon Bragg is a journalist for Momentum Media's Investor Daily, nestegg and ifa. He enjoys writing about a wide variety of financial topics and issues and exploring the many implications they have on all aspects of life.