Bond income has evaporated. For income-seekers, the solution is nuanced

While reflation of global bond yields has reinvigorated interest in the credit market and drawn investors back into the bond fold, many income-dependent investors feel shortchanged by plummeting cash distributions.

Investment researcher Zenith, in a review of its International Fixed Interest (IFI) universe, has identified a growing gap 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 contrast, the median portfolio yield-to-maturity (YTM) rate has more than doubled since FY22, increasing from 2.0% to 4.4% in the last financial year.

While noting that YTM remains an imperfect measure of future distributions and includes forecast capital appreciation, Zenith concedes the measure is widely used by fund managers as a guide to future returns.

This payments shortfall has challenged those investors – notably retirees – who rely on this income to “support their lifestyles [and] fund pension payments”.

As a result, 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 investors has been driven by two major factors: a depreciating Aussie dollar and elevated bond market activity, putting downward pressure on income.

Losses from currency depreciations, which Zenith notes is the largest driver of recent declines in distributions, are typically the result of a mismatch in timings between currency hedging cycles (done over short-term FX forwards in three-month periods) and the holding time for bonds, which is typically 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 recent period of elevated bond market activity has resulted in more active trading and positioning changes across managers, creating more realisation events and the potential for trading losses to offset income.

This has been particularly noticeable for investors with more active managers – those who frequently adjust portfolios and use derivatives, including futures, interest rate swaps and credit derivatives – who can introduce more income volatility.

Stabilising the income pipeline

Zenith argues that the most practical solution for portfolio managers (PM) to mitigate the impact of currency movements on distributable income is to make a taxation of financial arrangements (TOFA) election.

This will effectively match FX gains or losses to the financial year period when the underlying bond is sold or matures.

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

Properly enacted, a TOFA election demands from portfolio managers significant investment in back-office processes and systems. As a result, global bond managers have been reticent to make the election, with “only a few managers displaying the operational expertise to administer such an election”, Zenith said.

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

• Make fewer active trading decisions.
• 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 right fixed income strategy

For those that seek to prioritise stable income distributions, Zenith advises PMs to:

• Prioritise domestic fixed income, with limited non-AUD portfolio holdings; this investment process is more of a ‘buy and hold’ approach with less directional views.
• Check for a TOFA election, though Zenith cautions that a ‘fair value’ election will not mitigate the risk of income distribution volatility.
• Consider master/feeder fund structures. In these structures, currency hedging transactions are managed offshore in tax-light jurisdictions.