Philip Brown, Head of Research at FIIG Securities, shares his perspectives and observations on how bonds are responding to war, inflation and shifting expectations of what constitutes a 'safe-haven'.

Q: How have different segments of the bond market performed since the outbreak of war? 

Almost all asset classes performed very badly during the war, though there has been a recovery since. In my view, war is, ultimately, an exercise in physical and economic destruction. It diverts time, energy and resources away from productive activity and can reduce the world economy’s productive capacity. 

During the worst of the war most heightened phase of the market stress, equities performed particularly poorly, while many bonds held their value much better. The safest parts of the bond market, especially shorter-dated and higher-rated bonds, fulfilled their safe-haven role well. When equities were down around 10%, the safest bond market had moved less than 1% while continuing to provide income over the same time period.

Q: To what extent has the traditional role of government bonds as a safe haven been challenged by the war? 

The role of government bonds as a safe haven has been under stress for a few years now, particularly since the re-election of Donald Trump. The war and associated spending provides a good example of why. Government bonds have historically been seen as incredibly safe because governments were seen as strong, stable actors in the global economy with little doubt they would repay their debts. Governments are still very safe, arguably not as unquestioned as they once were. Inflation risk has become more prominent, and investors appear to be also more alert to risks created by government actions themselves.

Historically, the idea that a major Western government might struggle to pay its debt on time and in full seemed fanciful. However, the behaviour of Governments globally has, in my view, become more questionable in recent years, particularly in America, though also in Europe. This isn’t just about Trump. The breakdown in US budget processes, the lowering of the US credit rating, the frequent government shutdowns, the massive increase in Government debt on issue and the seeming inability of the US system to course correct have all contributed to making the notion of something strange happening to US debt repayments seem more and more realistic – even if still unlikely. This isn’t about a default, per se, it’s about the fact that there is now more US debt in the system than the markets want to buy without inducement. In this case “inducement” means higher yields and so also falling prices for long-term US Government bonds.

That's where the war comes in. Wars are expensive. From my vantage, if there’s already more debt than markets can comfortably absorb, and the government then suddenly needs to issue much more debt to pay for a war, the price of that debt will fall. Because the US government is so large, though, moves in US government debt affect government bonds around the world. The Australian Federal Government is still acting in the same traditional and responsible way, but we’re part of a global market and therefore still feel the ripple effects.

The war also affected global bond markets through inflation. Since bonds mostly pay guaranteed nominal sums, inflation is damaging to the value of the debt. In my assessment, the war saw information expectations rise - but perhaps by less than some might assume. Fixed income markets are pricing a short-term rise in inflation but also assume it will fade relatively quickly. Both inflation expectations and the anticipation of more debt in the system thanks to the war affect bond prices. 

Q: What impact would a 'higher-for-longer' inflation scenario caused by energy disruption have on bond portfolios? Are there specific segments of the fixed income market that would perform better or worse?

My short answer is that bonds as an asset class would likely in a long-term, high-inflation scenario, as would many other types of assets. However, the more nuanced view is that bonds are a very large asset class and many bonds are shielded from the worst effects of inflation. Some types of bonds even profit from higher inflation. A well-diversified and well-designed bond portfolio is well-shielded from inflation. A standard bond pays a fixed coupon and a fixed value at maturity. In a high inflation environment these standard nominal bonds have historically performed poorly as the RBA raises the cash rate. But standard nominal bonds are not the only sort of bonds.

There are also floating rate bonds, which pay coupons that rise as the RBA raises the cash rate. This structure provides investors with a higher income as inflation rises, though the link is indirect and runs through the RBA cash rate.

Finally, there are also bonds which pay coupons directly tied to the level of inflation. These inflation-linked bonds have cash flows that are mathematically determined by the inflation rate. When inflation is high these bonds have provided arguably a near-perfect hedge to rising inflation.

Q: It's been reported fund managers are moving toward inflation-linked bonds. Is this a strategy advisers could also adopt for clients? What inflation-linked bonds are readily available to direct investors in Australia?

Yes, inflation-linked bonds are certainly a strategy that advisers could adopt for their clients.

There are three main types of inflation-linked bonds in Australia:

1. Government Capital Indexed Bonds. These are readily available at multiple maturities. They have incredibly low credit risk and are also completely protected from inflation. Both the coupons the bonds pay, and the final sum returned at maturity, are tied to inflation. As a result, the yield is normally quoted as the return investors get over and above inflation. These bonds have historically had relatively low yields, but now the yields are now much more attractive. Shorter Government inflation-linked bonds pay something like CPI + 2.00%, while medium-length ones are nearer CPI + 2.50%. Very long CPI-linked bonds can yield as much as CPI + 3.00%, but clients should be aware of duration risk in the very long bonds. In volatile times a Government bond that pays inflation, plus an extra 2.00% or 2.50% is very attractive. We’ve seen strong demand for this sort of bond in recent weeks.

2. Corporate Capital Indexed Bonds.This style of bond is very rare, but Sydney Airport has issued a Nov-2030 maturing, inflation-linked bond which has the same structure as the Government bonds, but with some additional credit risk. The extra credit risk does also mean that the bond pays a higher yield, though. The Sydney Airport bond pays CPI + 3.30% or thereabouts. For a bond with very little risk, I would regard that as impressive return

3. Indexed Annuity Bonds. These bonds are a little different but pay a regular quarterly coupon that is indexed to inflation. As inflation rises, the value of the quarterly payment rises in lock-step. These bonds may suit clients wishing to live off the income. Investors should be aware though that, as an annuity, there is no return of capital at the end, instead the coupon stream is both interest and capital mixed together. These types of bonds are often issued by large infrastructure entities, for example, the Royal Women’s Hospital. The Indexed Annuity Bonds pay something like CPI + 3.00%.

Q: What key learnings regarding bonds, can advisers take from the past month?

The past month has highlighted that investing can be a difficult process – the world is a dangerous place. From my perspective, the key learning should be that bonds are a very safe asset class that will protect your investments in times of market stress. There are some nuances and not all bonds behave the same way, but a well-diversified bond portfolio will help when things get difficult. Advisers (and final investors) need to choose an allocation of bonds with that in mind.

Q: What is the key message advisers could deliver to clients re the performance and outlook for bonds in the current environment?

Bond yields have risen materially since COVID and now provide solid returns alongside their safe-haven status and defensive properties. Yes, there are still risky bonds out there, but a well-selected bond portfolio may provide solid and predictable income while also ensuring capital stability.

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