Investing in Long Dated Bonds
The Case for Duration
Interest rates all over the world are beginning to rise as economies and populations start to feel a sense of normality following the effects of Covid-19. Strong inflation data is putting pressure on central banks to raise their interest rates, and cool down economies following the vast levels of stimulus injected over the last two years. So as this ‘hiking cycle’ happens, how should your bond portfolio be positioned to potentially benefit from this process?
Rising rates are not necessarily bad for bonds, but it is the expectations of interest rate rises and falls that influences their price. As the expectation of interest rate rises increases, the bonds income is less favourable as investors can now access higher interest rates than they could previously. The bond market is forward looking, and it anticipates and prices in interest rate hikes (and cuts) from the central bank well before they announce their intentions to do so.
Currently, the New Zealand bond market is expecting (and pricing) our official cash rate (OCR) to peak at 3.5% and increase by +2% over the next year. I feel that these expectations are extreme and will not be realised. My base case is that the RBNZ will have to stop hiking well before this, and the demand for bonds and their income will increase. The best approach to benefit from this is to buy bonds with longer duration, which offer more leverage to this re-pricing.
What the Interest Rate Market is Pricing in
The best way to summarise forward rate pricing is to look at what’s priced over the coming year and also the expected ‘terminal rate’, i.e. where the market thinks the RBNZ will eventually get the OCR to. As described above the market is pricing in ~2% points of rate hikes over the next 12 months, with a terminal rate of approximately 3.5%. This would be the most aggressive track for interest rates since late 2009. The market also believes New Zealand will have more hikes in the next two years and a higher terminal rate than the US, where inflation pressures are arguably as severe (see chart below).
Although the market could always price in more hikes, I believe we are already now at levels that would be problematic for the New Zealand economy, and specifically at the household level, which remains highly leveraged to short-term interest rates (personal debt and fixed rate mortgage periods). If market expectations are realised, it would impose the largest increase in household debt servicing costs in over 40 years, which would have dramatic implications for longer-term growth and inflation outcomes.
Forward policy pricing for New Zealand and the US; Forward 1-month OIS
There has been a strong pipeline of corporate bond new issuance in 2022 so far which I expect to continue. These have been providing more attractive levels of income than in recent times. While the secondary market has also significantly re-priced (higher yields) allowing further opportunities. After a long period of time, we are finally seeing a shift of more advantageous conditions for bond investors as opposed to borrowers.