The ASX listing of Australian Commonwealth Government Bonds (ACGB) is a positive stgelopment in the evolution of the domestic fixed income market as it provides an avenue through which investors can more readily access the asset class. Nevertheless, investors, particularly those new to the asset class, need to be aware of the risks involved in investing in low-yielding fixed-rate instruments at this point in the cycle.
Regardless of whether exposure is via listed or unlisted means, if investors wish to add government bonds to portfolios in the current environment, it requires a clear understanding of why they are being added so that their value to portfolios is appreciated and does not create disappointment.
Our current view is that unless government bond exposures are actively managed, or are included in a portfolio for reasons other than security of capital and cash flows, now is not the time to be adding direct exposures to listed (or unlisted) government bonds. Buying fixed-rate instruments with a view to holding to maturity will lock in historically low yields and represent a lost opportunity for higher returns.
The vast majority of listed ACGBs are trading at premium prices, with corresponding low yields on 2- to 10-year bonds reflective of their inflated capital values.
Moreover, the instruments’ fixed-rate nature means their capital values (and potentially the value of portfolios) are likely to be more sensitive to interest rate movements compared to those of floating-rate instruments. The potential negative impact is magnified if, as many believe, we are at or very close to the bottom of the interest rate cycle.
An appreciation of the following attributes and dynamics is a prerequisite prior to investing in government bonds.
From a credit risk perspective ACGBs are low-risk.
The Australian Commonwealth Government is rated ‘AAA/Stable’ and remains one of a small number of sovereigns globally that continues to enjoy the highest rating.
ACGBs offer safety and security of regular cash flows (coupons) and redemption of capital at maturity.
Low Yield to Maturity
The issue confronting prospective investors; however, is that most ACGBs are trading at hefty premiums to their $100 face value.
While attractive annual coupons typically range between 5.25% and 6.25%, capital values are often in excess of $110 and for longer-dated instruments closer to $120.
Should ACGBs be held to maturity the net impact of solid annual returns coupled with capital losses on maturity (as the investor realises the bond’s $100 face value) results in yields typically in the 2.5% to 3.5% range.
An example is the ASX-listed 5-year Exchange-traded Treasury Bond (ASX Code: GSBA18) maturing on the 21st of January 2018. It provides an attractive annual coupon of 5.5% but will today cost approximately $113.60 and result in yield to maturity of 2.8%.
Capital Value Volatility
Aside from the lower capital values realised on maturity, there remains the risk that, in the period prior to maturity, yields will move higher as we end a 20-year bull market in government bonds. If portfolios are not actively managed a move higher in yields will translate to lower capital values and potentially negative returns as the value of coupons is offset by higher capital losses.
While yields could move lower (and capital values move even higher) as they did in mid 2012; we believe the risk is more that yields will move higher. The opportunity for further capital appreciation on ACGBs is limited. Chart 1 highlights the sustained move lower in 10-year ACGB yields over the past two decades.
Chart1: 10-year ACGBs Yields since 1994
Government Bonds Can Still Play a Role in Portfolios:
Whether retail investors should take advantage of the enhanced access to listed government bonds will depend on the role they want the bonds to play in portfolios. More particularly:
If ACGBs are being added to portfolios for the reasons outlined below their inclusion can be justified as the value provided extends beyond the low yields on offer. These roles include:
acting as an insurance policy against further market disruption and to provide capital value support within a wider portfolio of investments;
to act as a provider of uncorrelated returns to equity, as evinced by the attractive 14.3% return they provided in the 12 months to mid 2012 during which time the S&P/ASX 200 Accumulation Index realised a 6.7% loss; and or
to provide enhanced investing flexibility and liquidity.
By contrast, if the investor is focused on capital preservation and looking for the safety and security of a Commonwealth Government backed investment; they are likely to be better served investing their money in government-guaranteed term deposits earning annualised returns that are 1.5% to 2.0% higher with no market volatility. Despite scaling back its guarantee of term deposits in early 2012, the Australian Commonwealth Government continues to guarantee deposits to the value of $250,000 per account per financial institution.