Long Duration Bonds, and the negative performance over recent years

Holding long term bonds in any Australian, and global, investment portfolio is seen as a core strategy. However, with their recent negative performance we thought that it would be a prudent time to consider why we still hold them, and why they remain a part of your portfolio.

Bonds, what is their objective? Why are they considered a defensive asset? The primary objective of bonds is to provide stable returns in times of economic uncertainty. They are considered a defensive asset to protect capital when equity market volatility is high and provide consistent regular income from coupon payments.

As the world economy finds itself reversing the recent decade run of quantitative easing by Central Banks and falling interest rates since the Global Financial Crisis (GFC), and the more recent COVID crisis, we now find ourselves in an economic environment with risk-free cash rates back at levels not seen for 14 years.

Over the course of 2022 and the majority of 2023 Global Central Banks, and the RBA here, have been raising their cash rates as they continued their fight against ‘persistent’ inflation, implementing a tighter monetary policy and creating a narrative that these rates will be ‘Higher for longer’.

As we know, generally, that when interest rates rise the capital value of bonds fall, and vica versa. This current rising interest rate market has resulted in noticeable negative performance across the bond market since mid-2020, with the largest losses observed in 40 years in long duration bonds (primarily 10, 20 and 30 year dated bonds). This negative performance has recently been compounded, since June 2023, with the 10 year, and 20 year US bond yields rising exponentially in a short time, as illustrated in the chart below.

This has been an unwelcoming surprise for investors, especially for those with a low risk tolerance and prefer higher defensive asset allocations in their portfolios.

We have to ask ourselves after consecutive years of negative bond performance, have we seen the bottom of the sell-off, or will interest rates continue to remain or go higher?

It is important to note that a large proportion of this recent sell-off in bonds has been a result of the US Government budget deficit being much higher than anticipated with no real intention to reduce government spending. To fund the government spending, the US Treasury is required to issue more Bonds into the market, however, at higher interest rates to attract demand.

In Australia the focus for the RBA interest rate increases has been, and will continue to be, to keep inflation under control and return it to its 2%-3% target range by the end of 2025.

What does this mean for bonds? There is still the potential for yields to rise further, which may result in further losses and negative performance for bond funds. However, with the higher yields on offer, there is now a greater incentive to buy bonds which come with attractive income yields being returned to investors, and the longer-term potential of capital appreciation as rates stabilise and fall.

Sterling Planners Positioning

Over the past year with the significant rise in interest rates and the follow-on of rising bond yields, we have had a greater focus on recommending term deposits in client portfolios. In the short term they provide competitive interest rates, as well as the capital stable environment and protection from those rising yields.

Furthermore, we remain committed to the long term investment strategy for our clients and are now beginning to appreciate the higher yields and income on offer from bonds. Over the next 12 months, as noted above, we are optimistic that the negative returns from bonds will stabilise as Central Banks get closer to the end of their rate hiking cycle, and we are mindful that future interest cuts may generate a tailwind and positively affect bond prices and performance.

Should you wish to discuss any of the above further with please feel free to contact your Adviser on (02) 8904 9793.