Are bonds a better investment at this point in the cycle?

With all signals now pointing to the cash rate peaking somewhere between 2.85% and 3.1%, following the RBA’s surprise decision to raise interest rates less than expected (0.25%), investors can rightfully query whether the time is now right to be exploring the relative merits of buying bonds.

Assuming inflation has or is about to peak, investors are likely to begin shifting their focus from floating rates to fixed-rate bonds which in recent times have proved to be poor investments.

As a case in point, at 30 June 2022, which was close to bond’s low point, an Australian Government 11-year bond, issued in September 2020 at $100 face value, traded at $78.87.

Admittedly corporate bonds also fell, albeit by not as much due to their shorter time frames.

Bonds in a rising interest rate environment

Investors should remember that further out the term to maturity of fixed rate bonds, the higher the price drop will be within a rising interest rate environment.

That’s because future cash flows that collectively determine current bond prices simply aren’t worth as much.

The current bear market rally, which saw the ASX200 jump over 5% in two days – following the RBA’s more benign rate rise - may reflect the market’s conclusion that worst of the inflation lurgy is now behind us.

But is it?

But if the inflation Genie proves to be harder to put back in its lamp than the RBA’s last rate rise may suggest, investors may start wondering if indeed bonds are a better investment at this point in the cycle.

Investors should remember that volatility is not a friend to hold-to-maturity bond investors.

Despite consensus among economists that the cash rate will peak at or below 3.1%, the ASX 30 Day Interbank Cash Rate Futures Implied yield curve expects the cash rate to peak considerably higher at 3.57% in July 2023 and only two weeks ago it was as high as 4.31%.

That said, the trick at this point in the cycle is knowing where bonds add the most future upside.

Source: ASX

Corporate bonds surge

When contemplating bonds it’s important to note who’s prevailing view on both inflation and peak interest rates you’re buying into.

Talk of a global recession is mounting, and the implications for corporate revenues, especially within the banking sector, may encourage investors searching for greater [income] certainty, to look to the investment grade bond space where rates of around 6% p.a have been on offer.

Retail investors can take some guidance from institutional investors that have recently been on a bond buying spree.

While Australian corporate bond issuance recently nudged $73bn year-to-date, August was the strongest month on record.

Issuers over August included:

CBA (ASX: CBA) with a $4.5bn bond bonanza incorporating both fixed and floating rate options.

ANZ (ASX: ANZ) issued a subordinating bond with an issue yield of 5.9%.

While bond yields from low-cost ETFs have also been on the increase, income investors should be on the lookout for attractive new bond issues over coming months.