Fixed income had a difficult year in 2021. Australian bond investors experienced the worst returns in over 20 years with a negative return for the first time since 1999. The Australian 10-year government bond yield began the year at a paltry 0.97% before peaking at over 2.0% in October. The negative capital return as the price of bonds fell was only partially offset by the income generated by the low starting yield.
In a portfolio context, fixed income assets should serve three roles – diversification against equity risk, a stable income stream and liquidity to meet cash flow needs. The pandemic proved challenging for all three of these roles.
On the one hand, the amount of bonds available for private purchase hit record highs as government issuance surged. On the other, the availability of bonds for purchase hit a new low as central bank quantitative easing (QE) kicked into high gear.
Major economy money supply now totals about US$100 trillion. The amount of bonds available for purchase by the private sector constitutes a little more than 30% of that. The supply of bonds was large but so was the demand
for them by the central banks. The aggregate free float has decreased in the age of central bank bond purchases. In some markets the decline has been dramatic. For German bonds, the free float of available bonds is less than 10%. In the US it is just above 50% while in Japan it is less than 30%.
Macro liquidity: bonds available for private purchase (Bloomberg Global Agg mkt cap – FX Reserves) (trn)
Market illiquidity: ratio of available bonds to global money supply
Macro liquidity met with market illiquidity creates volatility. This weakens the diversification, liquidity and income benefits that come from owning fixed income bonds in a portfolio.
10% – The free ﬂoat of German government bonds available to investors.
Fixed income is no longer what it was. In the past 20 years, fixed income has generated a rolling negative, 12-month return, nine times. Six of those occasions were last year. On a rolling two-year basis, the return generated by fixed income has never been lower than it is today.
Average annual GDP growth (by decade)
Investors in global credit had a better experience over the year as default rates remained at very low levels. Issuance was high as the supportive policy environment provided an opportunity for companies to cut interest expenses.
The act of buying assets to keep interest rates down interferes with the natural order of the business cycle. Underperforming companies are artificially sustained and the cycle artificially extended. A healthy economy is one where businesses are allowed to go bust. This ensures efficient allocation of resources and so drives potential economic growth higher. The US economy has spent just three months in recession since quantitative easing began in 2009. Ironically, the longer quantitative easing is maintained, the slower, more lethargic, less dynamic economic growth becomes, the more quantitative easing is relied upon as a stimulant.
In this environment bond investors need to be clear about the risks they take. Separating out government bond duration and clearly defining a liquidity bucket is crucial. Investors can improve the total return of their bond portfolios by investing in shorter maturity bond funds and higher-income-generating credit strategies.
Number months US in recession (by decade)
US$1.7trn – Amount of bonds issued by US companies last year.