As we head into 2020, we should re-examine the role that bonds play in an investment portfolio. Head of Australian Fixed Income, Stephen Cooper, shares three ways that bonds can add value in a diversified portfolio of assets, and the scope for capital appreciation.

Bond markets typically perform well during periods of economic uncertainty. All else being equal, decelerating economic growth dampens inflationary pressures, increases the probability of interest rates heading lower.

That has certainly been the case over the last year or so. Economic conditions have softened both within Australia and offshore, and policymakers are debating whether further cuts are warranted.

The deteriorating economic background has been reflected in the local fixed income market. Yields on 10-year Commonwealth Government Securities have more than halved over the past 12 months, from over 2.70% in November 2018 to around 1.20% today. Remember, there’s an inverse correlation between bond yields and prices; the sharp move lower in yields has resulted in favourable returns from fixed income portfolios.

So far so good, but what now?

That’s great for investors who’ve had exposure to bonds recently, but what does it mean for the outlook going forward? Investors are increasingly questioning whether it might be time to lock in gains and remove allocations to fixed income investments. Official interest rates are negative in Europe and Japan and are being lowered elsewhere, most notably in the US. Moreover, increasingly accommodative policy settings by global central banks have driven yields below zero on more than a quarter of government bonds on issue worldwide. How much lower can they go?

It is understandable that investors are questioning whether bonds still have a role to play in portfolios.

In our view, they certainly do. In the interests of full disclosure, First Sentier Investors currently manages more than $15 billion of Australian fixed income securities, so our view probably won’t surprise too many people. But, even after putting unintended biases to one side, there remains a clear case to support ongoing allocations to defensive, income-oriented investments like bonds.

The asset class has an important role to play in most well-balanced, diversified portfolios, even though the future return profile is less appealing than it has been in the past.

The historical reasons for holding bonds include:

1. The low-risk profile 

Even though the overall indebtedness of most countries is increasing worldwide, the risk of default on debt issued by sovereigns in their own currency remains extremely low. Currently, Australian government debt is rated AAA by Moody’s, the maximum possible rating and one that’s only awarded to a handful of issuers worldwide. With the ability to print currency if required to meet debt repayment obligations, the likelihood of non-payment is very low.

2. A reliable source of income

Again, almost all bond issuers – including both governments and companies – are well placed to service their debt-servicing obligations and make regular coupon payments to investors.

While some global bonds are now showing negative yields to maturity, Australian government bonds still offer positive and secure income for investors. Most securities make coupon payments semi-annually. Yields and potential income are higher in corporate debt markets but with an inherently higher risk profile. With interest rates so low, most companies are currently able to comfortably meet their debt repayment obligations and profitability is holding up quite well among high quality firms. Accordingly, while the risk profile of corporate debt is always evolving, credit markets continue to offer opportunities for income-based returns with a relatively low risk of capital loss.

3. A hedge against falls in equities

Allocations to fixed income securities have historically helped preserve capital during equity down markets, effectively providing a cushion against falling share prices.

Even with yields below zero in some regions, the historical negative correlation between equities and bonds during periods of equity market stress is expected to persist worldwide. During times of elevated uncertainty, a ‘flight to quality’ into defensive assets with perceived capital security and plentiful liquidity would be anticipated, helping to maintain the historical relationship between equities and bonds.

Scope for capital appreciation from Australian bonds

If cash rates are lowered further in 2020, government bond yields could conceivably come under further downward pressure. This would push prices higher, augmenting income from coupon payments and lifting total returns. With yields at ~1.20% instead of ~2.70%, the expected return profile of Australian bonds is clearly lower than it was a year ago.

But, importantly, all of the above characteristics are likely to hold over the medium term, underlining the ongoing appeal of bonds as part of a broader asset allocation mix.

 

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