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01-08-2015, 08:25 PM
Don't let myths destroy your interest in bonds
Jeffrey Johnson
1050 words
29 Jul 2015
The Australian Financial Review
AFNR
English
Portfolio Just because the US central bank is on the verge of raising interest rates does not mean bonds are on the brink of collapse.
Terms such as "bond bubble" suggest to many investors that they need to question the role of fixed income in a portfolio and that perhaps the income-generating and defensive attributes of bonds no longer apply.
As if markets didn't present enough challenges, investors seeking income and exposure to defensive assets face a dilemma. How, or even why, should bonds be held following a multi-year period of strong performance, anticipating a more difficult period ahead?
For a variety of reasons the environment for bonds could become more challenging, but several oft-cited myths may be leading investors to ignore this important asset class.
Myth 1: Interest rates are headed
higher and prices on bonds are
headed lower
This is probably only partially true. Yes, most signs point to the US Federal Reserve lifting its target rate as early as September on the back of an economy that is finally, post-GFC, strong enough to withstand the removal of aggressive monetary stimulus. However, the Fed may not raise rates as quickly or to as high a level as in previous cycles.
It is also important to keep in mind that the Fed only controls short-term interest rates; higher long-term interest rates tend to be a result of strong growth and/or rising inflation expectations - neither of which we are seeing at present.
But the US may be nearly alone in its move upward. Here in Australia the last two interest rate moves made by the RBA have been cuts, with a bias towards more of the same as the economy continues to require stimulus to cure the hangover of the mining boom.
In Europe and Japan, policymakers are combating environments generally characterised by low growth, high unemployment, high debt and on-again-off-again deflationary pressures, meaning they may be hard pressed to raise interest rates this decade. The bottom line is that: 1) there is a divergent global picture with rates headed higher in certain regions, stable in some, and lower in others, and 2) short-term and long-term rates may react in different ways, meaning investors should focus less on interest rate predictions and more on the broader role bonds play in a portfolio.
Myth 2: Higher interest rates are
a bad thing for bond investors
As noted, higher rates may not occur as quickly or dramatically as some expect, but for argument's sake let's assume for a moment that rates do head higher (and after more than 20 years of falling interest rates this is bound to occur eventually).
But higher interest rates mean that future interest income and proceeds from maturing bonds are reinvested at higher yields. And higher yields attract buyers seeking higher income to the market, thus providing some support to bond prices.
Of course, there can be some short-term pain as bond prices fall in response to higher yields, but the picture is not necessarily as dark as some would have us believe. A good rule of thumb is that a bond fund's duration can be used to approximate its interest rate sensitivity. The Bloomberg AusBond Composite, for example, has a duration of 4.6 years, meaning that a 1 per cent rise in yields across the yield curve would likely lead to a price decline of about 4.6 per cent. International treasuries and global corporate bonds (duration of 7.1 and 6 years, respectively) have somewhat higher interest rate sensitivity, but are also highly diversified and, as noted earlier, divergent interest rate environments.
The duration can also be used to approximate the amount of time it takes for the higher income generated from higher yields to offset the initial price decline. For patient investors in accumulation and for investors with a multi-year need for income in retirement, higher interest rates can be a good thing.
Myth 3: A low interest rate
environment diminishes bonds'
role in a portfolio
Interest rates are low by historical standards, but so is inflation.
Over the next 10 years a reasonable return expectation for a globally diversified bond portfolio is around 3 to 3.5 per cent, but with inflation anticipated to be around 2 per cent, bonds are expected to fulfil their role as a generator of real returns.
Regardless of the outlook for returns, bonds provide diversification benefits to riskier asset classes such as equities: while they can experience periods of volatility, it generally pales in comparison to volatility experienced by equities, and high-quality bonds tend to provide considerable downside protection during equity market corrections and bear markets.
To be clear, an equity market correction or bear market is not Vanguard's central forecast at this point, but with valuations on equities globally generally on the high side, lower returns than those experienced over the last several years can be expected.
Investors should not rule out an increase in volatility - as we have seen recently - following an extended period of very low volatility.
Are bonds without risk? Of course not. Many segments of the bond market today - particularly higher-risk and lower-rated corporate bonds or "high-yield" bonds - offer very little compensation in the form of additional yield for their greater risk, making it an especially dangerous time for investors to "reach for yield".
Bond markets are unlikely to repeat the 7-plus per cent annualised returns of the past 15 years. And the risk exists that policymakers, with no historical playbook, will struggle to exit from exceptionally aggressive and accommodative policy measures.
The key for investors is to maintain reasonable return expectations, remain disciplined in the face of uncertainty about the interest rate outlook, and to remember that a rising interest rate environment is ultimately a good thing for investors focused on income and defence, despite the potential price declines that could be experienced in the short-to-intermediate term.
A globally diversified fund mitigates the risks and preserves the benefits of the asset class, which continues to serve a key role for investors in an uncertain, challenging and potentially more volatile investment environment.
Fairfax Media Management Pty Limited
Document AFNR000020150728eb7t0002n
Jeffrey Johnson
1050 words
29 Jul 2015
The Australian Financial Review
AFNR
English
Portfolio Just because the US central bank is on the verge of raising interest rates does not mean bonds are on the brink of collapse.
Terms such as "bond bubble" suggest to many investors that they need to question the role of fixed income in a portfolio and that perhaps the income-generating and defensive attributes of bonds no longer apply.
As if markets didn't present enough challenges, investors seeking income and exposure to defensive assets face a dilemma. How, or even why, should bonds be held following a multi-year period of strong performance, anticipating a more difficult period ahead?
For a variety of reasons the environment for bonds could become more challenging, but several oft-cited myths may be leading investors to ignore this important asset class.
Myth 1: Interest rates are headed
higher and prices on bonds are
headed lower
This is probably only partially true. Yes, most signs point to the US Federal Reserve lifting its target rate as early as September on the back of an economy that is finally, post-GFC, strong enough to withstand the removal of aggressive monetary stimulus. However, the Fed may not raise rates as quickly or to as high a level as in previous cycles.
It is also important to keep in mind that the Fed only controls short-term interest rates; higher long-term interest rates tend to be a result of strong growth and/or rising inflation expectations - neither of which we are seeing at present.
But the US may be nearly alone in its move upward. Here in Australia the last two interest rate moves made by the RBA have been cuts, with a bias towards more of the same as the economy continues to require stimulus to cure the hangover of the mining boom.
In Europe and Japan, policymakers are combating environments generally characterised by low growth, high unemployment, high debt and on-again-off-again deflationary pressures, meaning they may be hard pressed to raise interest rates this decade. The bottom line is that: 1) there is a divergent global picture with rates headed higher in certain regions, stable in some, and lower in others, and 2) short-term and long-term rates may react in different ways, meaning investors should focus less on interest rate predictions and more on the broader role bonds play in a portfolio.
Myth 2: Higher interest rates are
a bad thing for bond investors
As noted, higher rates may not occur as quickly or dramatically as some expect, but for argument's sake let's assume for a moment that rates do head higher (and after more than 20 years of falling interest rates this is bound to occur eventually).
But higher interest rates mean that future interest income and proceeds from maturing bonds are reinvested at higher yields. And higher yields attract buyers seeking higher income to the market, thus providing some support to bond prices.
Of course, there can be some short-term pain as bond prices fall in response to higher yields, but the picture is not necessarily as dark as some would have us believe. A good rule of thumb is that a bond fund's duration can be used to approximate its interest rate sensitivity. The Bloomberg AusBond Composite, for example, has a duration of 4.6 years, meaning that a 1 per cent rise in yields across the yield curve would likely lead to a price decline of about 4.6 per cent. International treasuries and global corporate bonds (duration of 7.1 and 6 years, respectively) have somewhat higher interest rate sensitivity, but are also highly diversified and, as noted earlier, divergent interest rate environments.
The duration can also be used to approximate the amount of time it takes for the higher income generated from higher yields to offset the initial price decline. For patient investors in accumulation and for investors with a multi-year need for income in retirement, higher interest rates can be a good thing.
Myth 3: A low interest rate
environment diminishes bonds'
role in a portfolio
Interest rates are low by historical standards, but so is inflation.
Over the next 10 years a reasonable return expectation for a globally diversified bond portfolio is around 3 to 3.5 per cent, but with inflation anticipated to be around 2 per cent, bonds are expected to fulfil their role as a generator of real returns.
Regardless of the outlook for returns, bonds provide diversification benefits to riskier asset classes such as equities: while they can experience periods of volatility, it generally pales in comparison to volatility experienced by equities, and high-quality bonds tend to provide considerable downside protection during equity market corrections and bear markets.
To be clear, an equity market correction or bear market is not Vanguard's central forecast at this point, but with valuations on equities globally generally on the high side, lower returns than those experienced over the last several years can be expected.
Investors should not rule out an increase in volatility - as we have seen recently - following an extended period of very low volatility.
Are bonds without risk? Of course not. Many segments of the bond market today - particularly higher-risk and lower-rated corporate bonds or "high-yield" bonds - offer very little compensation in the form of additional yield for their greater risk, making it an especially dangerous time for investors to "reach for yield".
Bond markets are unlikely to repeat the 7-plus per cent annualised returns of the past 15 years. And the risk exists that policymakers, with no historical playbook, will struggle to exit from exceptionally aggressive and accommodative policy measures.
The key for investors is to maintain reasonable return expectations, remain disciplined in the face of uncertainty about the interest rate outlook, and to remember that a rising interest rate environment is ultimately a good thing for investors focused on income and defence, despite the potential price declines that could be experienced in the short-to-intermediate term.
A globally diversified fund mitigates the risks and preserves the benefits of the asset class, which continues to serve a key role for investors in an uncertain, challenging and potentially more volatile investment environment.
Fairfax Media Management Pty Limited
Document AFNR000020150728eb7t0002n