NikkoAM's Fergus McDonald says as interest rates start tracking lower, bond investor smiles will widen. But returns in other sectors should improve too

By Fergus McDonald*

Relatively speaking, the New Zealand bond market has been on something of a tear recently. Nevertheless, given that of the many investment asset classes we’re perhaps the least inclined towards hyperbole, I think you’d be hard-pushed to find a fixed income manager who would call this – or indeed any other period – a Golden Age.

Channelling the Olympic spirit, I’d be prepared to go so far as to characterise this as a golden run. But then as our Kiwi triathlete Hayden Wilde found out, with any run, no matter how strong you look, there’s always the risk of being overtaken by a rival that had looked dead and buried coming back with a fresh burst of energy. But more on our share market shortly.

If this has been a golden or even silver run for the bond market, like our man Hayden, the strategy has been to hit the front early with a burst of acceleration and see how long we can hang on.

The tailwinds for this acceleration were of course provided by the inflationary environment that prompted the Reserve Bank of NZ (RBNZ) to raise the Official Cash Rate (OCR) from 0.25% in August 2021 to 5.50% in May 2023. Getting to the high point in rates involved some pain, but that investment pain is being rewarded by strong performances over 2023 and so far in 2024.

New Zealand’s bond market performance is inextricably linked to monetary policy, with interest rates the most effective tool the RBNZ has in its armoury to regulate the heat of the economy, and by consequence, inflation and bond yields. Therefore, while the RBNZ had maintained a low interest rate environment essentially as a crisis management strategy to help navigate us through the Covid period, bond performance stalled. But then while other investment classes toiled as the RBNZ sought to bring down the economic temperature, the bond market quickly grinded through its gears from a standing start to start outperforming most other domestic asset classes.

To illustrate this point, in the last calendar year our NZ bond fund returned 8.2% before tax and fees, against a market index^[1] of 6.2%. Over the same period, the NZX50 return was 3.5%.

Which brings us to today. With the OCR seemingly still stuck at 5.50% through to mid next year, and the RBNZ continuing to talk tough on managing inflation, nothing has seemingly changed. So the run should just continue, right?

Well, no. While the market and the economy are closely linked, they shouldn’t be confused for being the same thing – and the market has already begun to call bluff on some of the RBNZ’s tough talk, viewing it more of a question of when, not if, they’ll change tack. This has most obviously been seen in a drop in residential mortgage rates, but the impact has also been felt across the investment market too.

This all means that there’s a huge amount of interest in what Governor Adrian Orr and his decision-making committee will have to say, let alone choose to do, at Wednesday’s Monetary Policy announcement. Will they continue to walk the tough talk, or with inflation having now seemingly peaked and heading lower, will they give the markets what they’ve already priced in?

We expect policy to remain restrictive, just not as restrictive as it has been. This means the bond market run looks set to continue a while longer, albeit with a slightly less golden hue.

The RBNZ’s ‘neutral zone’ or level of comfort for the OCR is around 2.75% – so half of what we have now, but still markedly higher than where we’ve come from.  Therefore, we shouldn’t see future RBNZ activity as them putting their foot on the gas to reheat the economy; more like gradually easing off the brake.

As such, even at the bottom of the next cycle, we still expect bonds to be returning a healthy 3% to 4%. In all likelihood, this could be behind the resurgent equity market I mentioned earlier, which thrives on the promise of lower interest rates, greater consumer confidence and stronger economic activity. The probability of lower rates and the whiff of takeover activity has already seen it rebound from the doldrums, last month literally rising from zero to hero with returns of 5.9%.

Notwithstanding a number of short-term headwinds, we do think investor confidence will see a return of capital flows into equity markets. But this is not to say that it’s too late to make quality bond market investments.

As active investors in the fixed income market, we’re able to navigate changing economic times to position our funds to suit the prevailing conditions. By closely tracking the monthly Consumer Price Index data coming out of the US, rather than waiting on NZ’s quarterly reports, we anticipated falling inflation pressures here, especially as local economic data continued to be weak. With rates apparently peaking, our strategy has been to move to long duration bonds, locking in rates that will provide enduring value as interest rates begin to fall.

It certainly doesn’t look like you would be made a pauper by the bond market over the coming years, but with other sector outlooks improving as rates fall, there may be attractive opportunities to be had alongside it in the equity and property markets as interest rates continue to track lower. Indeed, for a successful, diversified portfolio (subject of course to individual circumstance), the general rule of thumb of a 60:40 split between equities and fixed income still stands up for long-term investors.

* Fergus McDonald is Head of Bonds and Currency at Nikko AM NZ.