Finally Income Returns to Fixed Income

Something remarkable happened recently that has not occurred for many years.  The income characteristics of fixed income actually have returned to levels that on an absolute and relative basis are attractive.  Perhaps for the first time in many years, the asset class might be making sense from an income perspective alone leaving aside any consideration of total returns which themselves look strong as we navigate toward the rate hike endgame. 

Historically, in Australia, the equity market which is a high yielding market has been a favoured, if not essential, component of investors’ portfolios seeking income.  A gross average dividend yield of ~4.2% over the last 10 years has compared to an average yield to maturity on the Bloomberg Ausbond Composite 0+ Index of 2.07%.  In short, if you specifically wanted income, bonds offered something but frankly not much. 

If there is a bright spot amongst the harrowing last 6 months in bond markets it might be that, for the first time that we can remember in a LONG time, fixed income actually is starting to look more appealing relative to other asset classes from an income perspective alone.  This is not something we have been accustomed to in Australia where income searching investors have understandably stayed underweight bonds. 

At present, the same Bloomberg Ausbond Composite 0+ Index has an average yield to maturity of ~3.7%.  Still short of the current ASX 200 Dividend Yield of ~4.63%.

However, of course the Bloomberg Ausbond Composite 0+ Index consists of ~89% Government debt of one form or another and ~92% AAA and AA rated securities.  By contrast, the ASX 200 has few companies rated AA let alone AAA.  The majority that are rated at all are A, BBB and below. 

So, if we look to compare ‘like with like’ perhaps a better comparison is between high quality corporate bonds and the ASX200 which, to a large degree, is comprised of such issuers. 

The following chart shows the yield of the Bloomberg Ausbond Credit 0+ Index against the dividend yield of the ASX 200 index. The credit index only has data going back to 2014 but we suggest the message is nonetheless clear.  For the first time in years the yield on an index of high quality corporate bonds has caught up to the dividend yield of the ASX 200. 

The above chart is actually quite remarkable from a number of perspectives.  Firstly, the bonds in the Bloomberg Ausbond Credit 0+ index sit at the very top of the capital structure for issuers. In other words, they rank at the highest level in terms of preference over the company’s cashflows being legal obligations that are not subordinated or subject to director discretion.  By contrast, equities are definitionally at the bottom of the capital structure and form the first loss component for the corporation. 

From this perspective alone, it could be argued that the dividend yield premium observed for most of the last 10 years is entirely justified given the higher risk born by equity investors (recognising that dividends form but one component of the equity investor return profile).  Equally, dividends are not fixed.  Of course, for many mainstays of the Australian equity market dividend stability has been a feature over many years but they are nonetheless variable and subject to director discretion.  Coupon is not.  Thus, an income stream that is riskier and subject to variability, all other things equal, ought to offer a higher risk premium/return. 

We of course acknowledge that many dividends in Australia are franked and therefore offer attractive after-tax returns for certain investors.  Neither are we arguing against equities for income seeking investors.  We are simply pointing out that for the first time in a long time the fixed income asset class might finally be recalibrating to be more in favour of income returns.  For most of the past 10 years returns from bonds have been overwhelmingly generated from falling yields driving prices higher even as coupon, yield income returns have been modest.  In the coming years, whilst we expect yields are likely to overshoot and recover, the balance of returns could be more heavily weighted toward income. 

This does not in the least surprise us.  We have been selectively adding to very high-quality names  that exhibit not only excellent fundamental characteristics but are offering higher bond yields than the current and expect dividend yield on their listed equity!  In a naturally income-oriented sector such as REITS, to see high quality names such as GPT and Scentre Group with bond yields well above their equity equivalent is remarkable. We have been tempted to ring up our equity colleagues and encourage them to start looking at debt! 

The move higher in corporate bond yields has been driven by rising government bond yields and, to a lesser degree, expanding credit spreads.  Either way, total returns are driven by a combination of the two. 

We continue to believe the RBA will not raise rates as far as the near 4% implied by market pricing.  To do so would wreak considerable damage on the economy and, in particular, housing and construction.  Even if this worse case were to transpire, such a move would be highly likely followed by cuts as inflation cooled and such a restrictive setting was paired back toward something more sustainable.  Either way, yields in the 5%, 6% and higher for high quality bonds with strong fundamentals are looking attractive particularly when compared to their riskier dividend cousins.