Across investor portfolios, we have bought the iShares Treasury ETF (ASX:IGB) which provides exposure to Australian Commonwealth Government Bonds. The holding will sit within the Australian Fixed Interest asset class.
We are positive on the medium-term outlook for ASX:IGB as the macro-environment has shifted significantly over 2022. The following provides background into what has changed and why now is an appropriate time to increase exposure to government bonds:
- Firstly, as a short fresher; movements in bond yields impact the price of bonds as payment coupons typically remain static. An increase in bond yields is a result of bond prices declining.
- Over the last 9 – 12 months, Australian Government Bond yields have risen as market expectations of rising interest rates increased and were ultimately proven right in early May when the RBA lifted the official cash rate for the first time since 2010. Interest rates have been at historic lows (0.10%) as emergency monetary policy was initiated back in 2020 in response to the impacts of COVID-19.
- The movement in yields have resulted in bond markets experiencing a significant retracement in price over the last 9 – 12 months resulting in their largest negative return observed in more than 40 years. This fall has occurred at the same time as equity markets have retreated significantly, which challenges the traditional diversification argument of holding defensive assets with multi-asset portfolios (positive return correlations).
- In mid-2021, 5 & 10-year Australian Government bonds yields were between 0.50% to 1.1%, an unappealing reward for the risk of significant drawdowns should Central Banks lift rates from historic lows. We were comfortable taking a defensive approach to fixed interest to preserve capital and limit the levels of duration (interest rate exposure).
- Fast forward 12 months and the risk – reward equation for duration has shifted, 5 & 10-year Australian Government bonds yield 3.5% – 3.7% as the market has “priced in” official cash rates to reach over 3.00% by the end of 2022 and close to 4.00% by mid-2023.
- While the RBA will continue to lift the cash rate, we believe the that current market expectations match or likely exceed what rate hikes will actually occur over the next 12 months.
- With more reward (attractive yields and reduced positive correlation to equity markets) and relatively less risk (market pricing in excessive interest rate rises) we believe now is an appropriate time to lengthen the duration within the Fixed Interest part of the portfolio.
- ASX:IGB provides ~5.7 years of duration, has a Yield to Maturity of 3.4% and is purely invested in Australian Commonwealth Government Bonds (no credit risk, and limited liquidity risk).
- We continue to believe that fixed interest should be treated as a defensive exposure within portfolios. As such, we continue to take a conservative approach to the asset class and are still positioned “underweight” duration relative to the combined fixed income benchmark, albeit at a narrower gap. However, should bond yields move higher we will look to increase duration exposure further.
To fund the purchase of ASX:IGB, we are removing Ardea Real Outcome Fund from the portfolio. Ardea operates a relative-value trading strategy with a highly skilled investment team implementing complex trades to deliver returns from fixed interest markets regardless of interest rate direction; an attribute we were attracted to and believe to an extent they have delivered on.
Ardea was added to portfolios in September 2020 when bond yields were at historic lows and we wanted to avoid significant drawdowns, such as what has recently occurred. Now with the risk – reward equation shifted we see ASX:IGB as a more attractive option in the current environment.
In addition to adding ASX:IGB, we are increasing the exposure to Janus Henderson Tactical Income Fund. The investment team at Janus Henderson have navigated the current bond market volatility well and looking forward see attractive pockets of value across the bond market which they are able to tactically manage.
As always, thank you for your ongoing support, it is very much appreciated. If you have any questions or would like more information, please contact your SBBWealth representative.
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