Do bonds still matter in a low interest world?
20 October 2019 | Portfolio construction
Rebalancing is such a simple, straightforward concept from an investor's viewpoint.
You set a target asset allocation that you are comfortable suits your personal risk profile and long-term financial goals. Then as markets or specific investments move up (or down) in value you periodically review and adjust accordingly to bring the asset allocation back into line.
It is a simple concept that is also executed by diversified multi-asset class options in major super funds, ETFs and managed funds, proving that the inherent simplicity of rebalancing does not mean it is any less meaningful in a professionally managed investment option.
While the concept itself is simple enough in theory, it does come with challenges in practice – particularly as an individual investor when it comes time to rebalance your portfolio to invest more of your hard-earned capital in an asset class that is holding out the promise of zero or negative returns.
In this context, we turn our attention to the humble bond, which in this case is the fixed income asset, rather than a certain high-profile spy movie character named James. Bonds have something of an undeserved reputation, often struggling to gather the same attention as their high-flying, fast-moving, headline-grabbing equity market cousins.
Volatile vs slow and steady. Dull vs exciting. That is the narrative that investors and financial advisers are accustomed to hearing and working with when considering bonds in a portfolio.
However, reliable and secure does have its moment in the spotlight – think most major market crashes of the past 30 years, particularly the GFC back in 2008. Where suddenly the seemingly unlimited potential for share markets to fall further, faster, the steady, secure returns that bonds have traditionally offered become incredibly appealing to investors around the globe.
Vanguard has had a long-standing view of the role of bonds in a diversified portfolio to provide a valuable safe harbor by providing a dampener on the volatile ride that share markets can deliver. But what about when interest rates fall, fall some more and then, in some parts of the world, hit zero or even go into negative territory?
Do bonds still have a role or should investors rethink their entire approach to portfolio construction?
While this is new territory for Australian investors, US, European and Japanese investors have already experienced periods of low or zero interest rates in the post-GFC world. Like most other developed economies, Australia's cash rate is now at record lows and central banks do not show any signs of stopping cuts.
The ambition is that cutting rates will stimulate the economy by boosting spending.
Greg Davis, Vanguard's Chief Investment Officer, was visiting Australia this month, where he observed that "we have yet to see signs that negative interest rates are effective - rather we have no data to prove that it is ineffective. However, when rates are so low, rather than boost spending these cuts may result in an adverse impact on consumer confidence with consumers saving instead of spending".
So why should an investor still hold bonds in an environment of near zero or negative interest rates? Despite low or negative yields, bonds still play a fundamental and important role in a portfolio as a diversifier, balancing the volatility of equities and other growth assets to reduce the variability of portfolio returns. That is evident in the strong appetite for government-denominated bonds/debt that we have seen this year - investors clearly still value the safe harbour of owning government debt.
Another perspective is that, given rate cuts are intended to encourage investors to buy riskier assets, strong demand for government-denominated debt shows that investors are valuing security over return in this environment.
It is important to note, however, the significance of an investor's time horizon in determining an appropriate allocation to bonds. If an investor's time horizon is shorter than the maturity of the bond, that investor has greater exposure to price appreciation or depreciation of their bond portfolio. Accordingly, the lower risk nature of a government bond is better suited to an investor who has a greater time horizon than the maturity of the bond.
An Australian investor investing in international bonds should also consider the currency risk. The risk is another source of portfolio volatility and as a result may have a significant impact on the overall bond portfolio investment return, hence currency-hedged bond solutions can be an optimal way of reducing currency risk where desired.
At a time when investors may be concerned at equities being overvalued, the prospect of near-zero returns is a lot more appealing than a significant equity downturn of -10%, -20% or even higher.
However, an investor's asset allocation decision should pay a strong deference to the investor's time horizon. The ability to put that original rebalancing decision in a long-term context is truly valuable at times when markets appear out of balance, and so the short-term defensiveness of bonds can still play a meaningful role when compared to the long-term growth prospects of equities.
In that context, for investors looking to rebalance in a period of low-to-negative interest rates, the right question might not be 'should I have exposure to bonds?', but rather 'can I afford not to?'
This article originally appeared in the Australian Financial Review on 18 October 2019
Written by Robin Bowerman, Head of Corporate Affairs at Vanguard.
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Robin Bowerman, Head of Corporate Affairs at Vanguard Australia, shares investment and personal finance insights gained from over two decades in the finance industry as writer, commentator and editor.