Bond income has evaporated. For income-seekers, | Australian Markets

While reflation of international bond yields has reinvigorated curiosity within the credit market and drawn traders back into the bond fold, many income-dependent traders really feel shortchanged by plummeting money distributions.

Investment researcher Zenith, in a review of its International Fixed Interest (IFI) universe, has recognized a growing hole between bond funds’ average portfolio yields and income distributions.

“Cash distributions have averaged less than 1% over the past three years, despite portfolio yields increasing materially, following the 2022 bond market sell-off,” Zenith writes.

By distinction, the median portfolio yield-to-maturity (YTM) price has more than doubled since FY22, rising from 2.0% to 4.4% within the final financial 12 months.

While noting that YTM stays an imperfect measure of future distributions and consists of forecast capital appreciation, Zenith concedes the measure is broadly utilized by fund managers as a information to future returns.

This funds shortfall has challenged these traders – notably retirees – who depend on this income to “support their lifestyles [and] fund pension payments”.

As a consequence, Zenith notes, “advisers are being forced to find alternative sources of liquidity, including selling defensive and growth assets to meet cashflow requirements and pension payments”.

For the researcher, this precipitous fall in income for Australian bond traders has been pushed by two main elements: a depreciating Aussie greenback and elevated bond market exercise, placing downward strain on income.

Losses from currency depreciations, which Zenith notes is the most important driver of latest declines in distributions, are sometimes the consequence of a mismatch in timings between currency hedging cycles (completed over short-term FX forwards in three-month durations) and the holding time for bonds, which is often years.

“Based on our research, the timing mismatch between the average tenor of FX forwards and the holding period of bonds, coupled with the depreciating Australian dollar have been the main contributor to the recent decline in fund distributions.”

In addition to unfavourable currency conversions, the latest period of elevated bond market exercise has resulted in more energetic trading and positioning adjustments throughout managers, creating more realisation occasions and the potential for trading losses to offset income.

This has been notably noticeable for traders with more energetic managers – those that continuously regulate portfolios and use derivatives, together with futures, rate of interest swaps and credit derivatives – who can introduce more income volatility.

Stabilising the income pipeline

Zenith argues that essentially the most sensible answer for portfolio managers (PM) to mitigate the affect of currency actions on distributable income is to make a taxation of financial preparations (TOFA) election.

This will successfully match FX good points or losses to the financial 12 months period when the underlying bond is offered or matures.

However, Zenith does acknowledge that correctly administered TOFA elections are riddled with complexity.

Properly enacted, a TOFA election calls for from portfolio managers vital investment in back-office processes and systems. As a consequence, international bond managers have been reticent to make the election, with “only a few managers displaying the operational expertise to administer such an election”, Zenith mentioned.

From a portfolio management perspective, Zenith notes, bettering income stability would require managers to:

• Make fewer energetic trading selections.
• Reduce turnover in portfolios.
• Shift investment philosophies to prioritise distribution stability over pure outperformance.

“While possible, these changes are difficult to implement in practice, as they may conflict with a manager’s broader strategy and performance objectives.”

Selecting the precise fixed income strategy

For those who search to prioritise secure income distributions, Zenith advises PMs to:

• Prioritise home fixed income, with restricted non-AUD portfolio holdings; this investment course of is more of a ‘buy and hold’ method with much less directional views.
• Check for a TOFA election, although Zenith cautions that a ‘fair value’ election is not going to mitigate the risk of income distribution volatility.
• Consider grasp/feeder fund buildings. In these buildings, currency hedging transactions are managed offshore in tax-light jurisdictions.