Franklin Templeton Investments says that while they do not necessarily expect a significant sell-off in Australian bonds, investors risk being caught off guard if overly pessimistic signals implied by low bond yields prove overdone. Preparing now for a change in the direction of rates is prudent for investors, rather than being forced to react later.
In view of the recent Fed interest rate hike, Andrew Canobi, Director of Franklin Templeton’s Australian Fixed Income team, emphasised the importance of implementing investment strategies that take into consideration the increasing divergence of Australian monetary policy from that of the world’s largest economy, and preparing fixed-income portfolios accordingly.
“Australian bonds have historically had a reasonably high correlation to movements in US yields, and volatility in global bond yields will likely challenge traditional Australian bond investors with long duration exposures. The potential bond portfolio losses from a rise in yields are further exacerbated by the market’s high levels of sensitivity to changes in interest rates,” said Canobi. “Whilst yields could decline further and stay low for a period, the income generating qualities of government bonds has largely evaporated in recent years making continued outperformance almost entirely dependent on yields continuing to drop to new lows. Importantly, these short-term capital gains could be just as rapidly given back if yields reverse their downward direction”.
“Additionally, strategies that rely solely on risker credit securities may face challenges in 2016, with risks associated with mergers and acquisitions rising and commodity prices remaining under pressure. Select opportunities in non-government debt will be strong, as the recent widening in spreads has meant otherwise relatively low risk entities are now compensating investors exceptionally well to take credit risk, but careful security selection has never been more essential. We believe that investment approaches focused on shorter but dynamic duration management as well as judicious credit security selection may still deliver attractive returns above cash”.
“Whether we have seen the low in Australian bond yields will likely be determined by what’s happening in the domestic economy, as well as actions from the Reserve Bank of Australia (RBA). We could see the RBA act on its easing bias and lower the cash rate, but the RBA is clearly only prepared to act on this bias if conditions deteriorate”, Canobi added.
“To help preserve capital, investors may want to consider rebalancing by moving some of their traditional fixed income strategies into ones which allow them to invest in a wide variety of securities and strategies that seek to counteract specific types of risk”.
