Written by Tom Stanley, Investment Adviser, October 2023
Summary (Too Long Didn’t Read)
- Although we may not admit it, we all look at the past for clues to the future.
- Our focus on the past is exacerbated by recent events being easier to recall – we are prone to what is known as ‘recency bias’ and it can prompt us to make miscalculated bets and poor investment decisions.
- Bonds have had a horror run of recent, bad enough for many investors to dismiss them – 2022 was the worst year for Barclay’s U.S. Aggregate Bond Index since records started in 1976.
- With interest rates reset higher and in restrictive territory, bonds now have the potential for share market like returns for much lower risk – the sort of opportunity not seen since for 15+ years.
- Bonds and Bond Funds with longer maturities than 5 years can be used to lock in high interest rates for longer than you can with traditional term deposits (typically max 5 years).
To those ready for another monthly musing – thank you for your time, without further ado, lets dig in…
The Coin Flip – A Bias Exposed
If I flipped a (fair) coin ten times in a row and each time it landed on heads, what are the chances it lands on heads next time I flip it?
Find yourself wanting to say something other than 50/50?
Don’t stress, it is a natural response.
The above example shines a light on recency bias – No matter how remarkable previous events might have seemed, the coin flip always has a one-in-two chance of landing heads or tails.
The recency effect (or recency bias) is a term first ‘coined’ by the psychologist Hermann Ebbinghaus, who became famous for his work on the experimental study of memory. It’s a cognitive bias that affects our decision-making process by causing us to recall more recent occurrences better than previous ones. It happens when people place too much emphasis on recent evidence, which can lead to mistakes in judgment and thinking.
Today I want to consider how recency bias may be influencing our expectations around CASH or TERM DEPOSITS and an asset class you have likely heard of but may not be so familiar with – BONDS or FIXED INCOME.
Disclaimer: Please do not take this as a note stating ‘cash is trash’, we deliberately use cash and cash funds as a defensive allocation for clients, but outside of 1-2 years I believe there is a real opportunity for equity like returns from bonds – read on for more context.
Why Zoom in on Bonds (also known as Fixed Income)?
Banks in NZ advertise the heck out of their latest term deposit and home loan rates, its become second nature for most to talk about the interest rates on cash or term deposits.
The news and commentators often talk to the share markets as a proxy for the health of the economy.
But we rarely if ever hear of bonds or fixed income in the mainstream media – This silence despite bonds making up around 43% of the $96.2bn of funds in all of KiwiSaver.
Why don’t we hear more?
For me there are potentially 3 reasons:
- Fixed Income returns in the past few years haven’t been exciting,
- Fixed Income investors use lots of jargon like ‘Yield to Maturity’ that most don’t understand,
- The math behind returns on fixed income is not that intuitive.
Let’s unpack some of those points…
Historical vs Future Returns:
I mention above that returns in the past few years haven’t been exciting for bonds – that comment is not technically true, 2022 was a dumpster fire of a year for fixed income investors – According to the Barclay’s U.S. Aggregate Bond Index, 2022 was the worst year in since they started recording in 1976 for bonds. Since 1976 in fact, we’ve only have 5 negative years in the bond market. Last year, 2022, was historically bad – down 13%.
If we look at returns across asset classes over the past 10 years, including the horrific time had last year by bond holders (and year to date in 2023) how do they stack up?
Per Morningstar’s September 2023 quarterly KiwiSaver report – the 10 year returns for Kiwi investors across different asset classes have been:
Bonds have had their worst year on record, yet returns are still roughly in line with Cash over the past 10 years – a point that highlights how poor cash returns have been for some time – Even considering the sharp rise in interest rates in the past 18 months that has acted as a strong tailwind for cash of recent.
10% per year on average returns for international shares is especially impressive considering markets have yet to regain their 2021 highs – It is worth noting this 10% per year return is roughly what stock markets have produced year over year for the past 100 years (albeit not in a straight line as we are all experiencing currently).
What the above table shows us is that effectively since the Global Financial Crisis in 2008, the only place to invest for a material real return has been shares – Reserve Bank’s moves to suppress interest rates globally, made investing into cash and fixed income a low return play.
But with inflation bursting forth and interest rates breaking higher since 2022 – that picture may have changed. In his latest note (Further Thoughts on Sea Change) Howard Marks offers the question:
“What do you consider to have been the most important event in the financial world in recent decades?”
“Some suggest the Global Financial Crisis and bankruptcy of Lehman Brothers, some the bursting of the tech bubble, and some the Fed/government response to the pandemic-related woes. No one cites my candidate: the 20% decline in interest rates between 1980 and 2020.”
The problem with constantly falling interest rates is potential returns from fixed income shrink and falling returns in traditional yield plays led investors (retail and institutional alike) into higher risk and in some cases leveraged plays to generate returns.
Marks carries on with:
“Relatively few investors today are old enough to remember a time when interest rates behaved differently. Everyone who has come into the business since 1980 – in other words, the vast majority of today’s investors – has, with relatively few exceptions, only seen interest rates that were either declining or ultra-low (or both). You have to have been working for more than 43 years, and thus be over 65, to have seen a prolonged period that was otherwise.”
The key point of Mark’s latest note is that ‘if the declining and/or ultra-low interest rates of the easy-money period aren’t going to be the rule in the years ahead’ then we should look at other investments to lead the way – the problem?
Like the coin flip example at the beginning of this note, periods of significant outperformance of one asset class (stocks) vs all others are the perfect setup for recency bias.
Compounding this problem is the recent performance of bonds. The 3-year returns from the same Morningstar report are starkly different to the 10 year returns:
This rolling 3-year period of extremely poor bond returns has taken away what many thought were conservatively accrued gains, leaving cash like returns after 10 years of investing – it is no wonder cash is considered king and bonds are off most people’s Christmas list.
What if we look to the future?
If interest rates remain elevated, or even come down a little the future returns of fixed income looks promising (more below). However, higher interest rates are likely to be a headwind for company profits (stocks), property, and anyone with significant amounts of leverage. Sure, there will always be performers, but with higher costs of borrowing, and higher interest from lower risk investments, there will be more competition for each and every invested dollar.
PIMCO, who manages the Hunter Global Fixed Interest Fund, published the below video titled “High Quality Bonds Offer Equity-Like Return Potential”. In this video Mark Kiesel and Mohit Mittal point out the attractiveness of current yields. They also point out that they see potential for yields to fall over the next few years as central banks are close to the end of their tightening cycle, potentially spurring on capital gain for bond investors.
Note: It is worthwhile mentioning that while interest rates could fall from their current levels, they could still remain higher relative to the 2008-2020 period where near 0% interest rates were the norm (in line with Howard Marks’ views mentioned above).
Mark Kiesel’s comment “we are seeing yields of 6.5% to 7% on high quality fixed income assets”, prompted me to consider how bond yields stack up vs term deposits – so I dove into the latest fact sheets from a range of fixed income managers we actively research, monitor and invest with:
Click here for Fact Sheets mentioned above.
* Based on latest fund fact sheets and quarterly reports
** Estimated Yield to Maturity most recent fact sheet is August 2023 (5.04% yield to maturity).
For clarity I have compared yield to maturity with the per annum return of a term deposit as yield to maturity is the expected annual return if all bonds paid their interest as expected and were held until they matured (like what most would expect to do when investing into a term deposit) – for more detail on the math behind ‘yield to maturity’ see this article from the team at Kernel.
Two key points turn up from inspection of the above table:
- Durations stated above indicate that you can use bonds to lock in higher interest rates for longer than you typically can with term deposits (i.e. more than 5 years).
- Yields are generally higher on bonds vs long dated term deposits even when considering broadly diversified investment grade or government bond focused mandates.
The Kicker? If Reserve Banks Cut Interest Rates
In a recent update, Harbour Asset Management’s Hamish Pepper flagged that in the next few years he “see scope for interest rates to decline as it becomes clear that tight monetary policy is having the desired effect” (i.e. higher interest rates have slowed the economy and brought inflation back to target levels). This scenario resonates with the comments made in the above PIMCO video, and this is where the bond math comes in (and can be a little confusing).
If interest rates are cut by reserve banks, bonds that have already been issued would continue to accrue their current yields (until they mature) meaning they would be even more attractive than they are now… this attractiveness is reflected in capital appreciation of the bond.
I am not going to dive into the details in this note, but why would bonds go up in price if interest rates were cut? Time for an example:
- Assume we have a bond that is worth $100 and paying 6% interest, i.e. $6 per year for the next 5 years.
- Also assume prevailing interest rates in the market are 6%.
- Now assume the reserve bank cuts interest rates and the prevailing market interest rates fall from 6% to 5%.
- Your bond would still be paying you 6% when new bonds are being issued at 5%. If you were to sell your bond, you could ask for the buyer to pay more for it, as they would get $6 per year in interest rather than $5 per year if they bought a newly issued bond paying 5%.
- In effect, the lever that is pulled to find the fair value of your bond is the price.
- To turn your $6 per year of interest into an effective 5% interest payment, the price of your bond would have to increase in value from $100 to $120 – a 20% capital gain you could choose to realise in addition to the yield you would continue to pick up.
While this is a simplified example for illustrative purposes only, it is designed to show that when interest rates fall, prices of traditional bonds rise, and vice versa. If you are wanting a general rule of thumb, for every 1% increase or decrease in interest rates, a bond (or bond fund’s) price will change approximately 1% in the opposite direction for every year of duration. For example: If interest rates were cut 1%, the PIMCO fund mentioned above would see a price appreciation of +5.5% (5.5 years x 1%) in addition to the 7.1% yield to maturity.
Risks to the claim ‘Equity Like Returns for Fixed Income Volatility’:
As with any investment, there are always risks – what are the environments in which bonds could struggle?
First, individual borrowers can default and fail to pay. It’s the main job of the active portfolio manager to weed out the non-payers, and history shows it can be done. Isolated defaults are unlikely to derail a well-selected and well-diversified portfolio.
Second, inline with their name ‘fixed income’ instruments have limited potential for upside compared to equities, property, or other growth assets. It’s entirely possible that growth assets once again surprise on the upside and outperform in the years ahead. While this doesn’t necessarily impair fixed income returns, this is the FOMO risk, which can never be ignored.
Third, fixed income assets are also subject to price fluctuations, meaning having to sell in a weak period could cause losses to be realized. But fixed income assets are far from alone in this regard and tend to bounce around less than their growthier counterparts, shares – if you do have immediate requirements for cash, a cash fund is the place to be (more on cash funds here and here).
Fourth, the returns highlighted throughout this note are nominal returns. If inflation isn’t brought under control, those nominal returns could lose significant value when they’re converted into real returns.
Finally, reserve banks could take interest rate back down to zero or 1%, meaning the yields on cash or fixed income recede accordingly. Fortunately, by buying multi-year fixed income exposure, an investor can tie up the promised return for a meaningful period. Reinvesting or realisation of capital gain will have to be dealt with upon maturity or sale, but if you hold one of the bond funds outlined above, you will at least have secured the promised yield – perhaps minus losses on defaults – for the term of the instruments.
- While returns on fixed income or bonds has been horrible the past few years, do not let recency bias hold you back.
- While term deposit rates are better marketed and understood by Kiwis – Fixed income assets should not be ignored – looking ahead, they have the potential to provide “Equity like returns with 1/3 to ½ the volatility” (PIMCO).
- Even if interest rates remain at their current restrictive levels, you can lock in +7% returns for 5+ years on high quality fixed income assets. If interest rate cuts do materialise over that time period, there is scope for additional capital gain.
Being aware of our psychological flaws such as recency bias hopefully means we are not caught off guard, betting on another heads just because the previous coin flips were all heads… Being in bonds has been a tough journey recently, be prepared for a brighter future.
I appreciate this month was a bit of a deep dive with some more technical material – if you have any questions or how the above comments impacts your investments or portfolios, please write to me at firstname.lastname@example.org or feel free to book a call with your adviser via one of the below links.
We are here to help.