With yields at record lows and negative returns on bonds being an absolute certainty, is there really a point to investing in fixed interest? Aman Ramrakha from CBA Wealth Management Advice believes there is more than meets the eye.
A number of commentators and investors alike are questioning the allocation to fixed interest (specifically bonds) in a portfolio at a time when bond yields are at all-time lows.
The recent rally in equity markets has exacerbated the notion of a ‘bond bubble’.
Fixed interest, traditionally the source of yield (income) and capital stability, faces the prospect of struggling to deliver one or both of these objectives in the short to medium term.
There is no doubt that the above concerns are valid but let’s look a little bit deeper.
Yields are low, interest rates must go up
Noting the inverse relationship between bond prices and yield/interest rates suggests that a negative capital return is an absolute in a rising yield environment.
Importantly, a bond portfolio’s total return comes from two sources – capital return, which is generally challenged in a rising yield environment, and income return – which generally benefits from a rising yield environment as interest and the money from maturing bonds is reinvested at higher rates.
It is important to note that the size of the rise in yields and the period of time over which that rise occurs that determines returns.
Relative to long term history, bond yields have been trending down and are currently trading at the lower end of the range.
Much has changed during that period; global growth dynamics have slowed and ongoing fiscal and political uncertainties have not helped.
Ongoing unconventional policy implies underlying support for bond yields. Whilst the ‘printing’ of money is elevated relative to history, it is certainly not proving inflationary at this stage.
There appears to be sufficient slack in the global economy with low capacity utilisation and high unemployment rate to act as a buffer against inflation.
With the Australian growth outlook likely to disappoint (soft labour market and a manufacturing sector challenged by a high currency and high cost base) coupled with a global growth outlook of sluggish at best, further rate cuts to support the economy are not out of the question.
Yields in Australia we believe will therefore remain at relatively low levels for some time. However, with positive real yields, Australian government bonds are attractive amongst global government bonds.
What about equities?
Tactically asset allocating between fixed interest (bonds) and equities is a skill that eludes most of us. Boring as it may seem a properly diversified portfolio will have both.
On a simple basis, equity earnings or dividend yields appear elevated versus bond yields. However, dividends are more comparable with bond cash-flows.
Dividend “yield” on equities comes from an entirely discretionary cash-flow. A bond yield comes from a contractually obliged cash-flow, unless of course an issuer defaults.
This is one reason why there is an equity risk premium – a required excess return over a risk free (bond) rate.
A point to consider here is whether cash that is currently on the sideline should be allocated to equities rather than removing fixed interest allocations in favour of equities.
Of course the individual investor’s objectives will be the determinant in each case.
1994?
The 1994 bond market sell off was induced by aggressive tightening of policy rates. During 1994, the US Federal Reserve funds rate increased 2.5 per cent, while the RBA cash rate increased 2.75 per cent.
At this stage we do not see a repeat of the bond sell-off in 1994 and a number of factors would indicate the risk is low at present. These include:
- Economic growth is weaker and more fragile;
- Inflation is lower and low inflation expectations are more entrenched than was the case twenty years ago; and
- In Australia, there is a short term risk to growth as mining investment slows and non-mining activity remains soft.
The US Federal Reserve has indicated it’s unlikely to raise interest rates as long as unemployment is above 6.5 per cent and this looks likely to remain the case at least for the next year whilst in Australia the debate is still about whether rates need to be cut again.
The European Central Bank continues to indicate a commitment to monetary policy remaining accommodative for as long as needed.
So at this point in time, monetary tightening, which was the trigger for the 1994 style bond sell off, looks unlikely in the near future.
Most importantly, central bankers are much better at communicating their intentions to the market than was the case in 1994.
A recent speech by Janet Yellen, Vice-Chair of the US Federal Reserve highlighted the increased transparency exhibited since the early 2000s.
This transparency significantly reduces the chance of a policy surprise catching the market off guard.
Summary
We continue to advocate fixed interest remain a core part of a well-diversified portfolio with active allocation across fixed interest sectors as markets evolve.
In the scenario that yields gradually grind higher, we believe it is important to take an active approach and position fixed interest exposure to mitigate some of the rising yield risk.
With this being the case, active bond managers with broad mandates allowing them to invest and rotate across the broad spectrum of fixed interest assets as well as utilising various tools such as asset allocation adjustments, reducing interest rate duration, adding inflation-linked and floating rate bonds, will be better placed to protect investor portfolios if this scenario is realised.
It is also important to manage investor expectations. Double digit returns from fixed interest is not likely to be the norm in the near future.
Aman Ramrakha is the executive manager of research at CBA Wealth Management Advice.
