Investments, Strategy

No substitute for bonds

Let’s face it: cash is still king with Australian investors. This was once again confirmed in the recent Vanguard/Investment Trends SMSF study showing cash makes up nearly one-quarter of investor portfolios.

In these portfolios, cash appears to be used as a proxy for bonds, which have little or no apparent representation.

In times such as this, where fears of interest rate rises are heightened, there is likely an even greater barrier to the adoption of fixed income exposure.

But there are compelling, enduring arguments for including a broad, global allocation to bonds in investment portfolios. Here are some things to consider.

Cash for short term, bonds for long term

Like bonds, cash may display a low correlation to equities – a low correlation means it can provide good diversification. Unlike bonds, however, cash is better suited as a short-term vehicle for liquidity needs and emergency reserves rather than a longer-term investment.

The Vanguard/Investment Trends research showed that in total there is $50 billion in excess cash waiting in the wings to be invested when the right opportunity arises. But if investors are holding this in term deposits while they wait for this ideal investment or time to enter the market, this introduces liquidity risk as there are generally penalty fees imposed if you need to quickly release your cash.

Investment in term deposits can also introduce reinvestment risk. That is because your principal is fully returned to you at the end of the term so you are exposed to any interest rate changes that have occurred in this time. This can have a substantial impact on your return going forward if attractive interest rates are no longer on offer.

Good-quality bonds will offer higher expected returns over the long term for investors willing to take on slightly more risk. These higher returns are compensation for investors taking on increased levels of interest rate risk and credit risk exposure, providing greater liquidity to investors versus term deposits. In this sense, bonds generally suit an investor with a longer investment time horizon. Over time, bonds also provide better protection against the effects of inflation.

Go global, not just local

Vanguard’s research shows that including an allocation to international bonds significantly expands an Australian investor’s portfolio diversification and opportunity set, without decreasing its total return.

Investing in bond markets outside of Australia may seem to some like it might add risk. In fact, through exposure to multiple markets, a global bond allocation can add diversification and reduce market-specific risk factors, with hedging important to eliminate movements in local currencies.

This is because factors influencing the Australian bond market may not apply to other bond markets (and vice versa), so adding global bond market exposure can smooth returns for clients over time.

This is diversification that can help investors reduce both portfolio volatility and risk.

When investors make an allocation to global bonds, they are gaining exposure to more securities versus investing only in local bonds, but in addition they are gaining exposure to other markets’ distinct economic environments and cycles.

This is important as even though bonds from an overseas market might be more volatile compared to Australian bonds, a portfolio that includes bonds from other markets benefits from their diverse characteristics, with the end result being a smoothing of returns over time.

In order to analyse how different bond markets compare – and to understand what risks or gaps a purely domestic investment might have – you can break the global investment-grade bond market into sectors, bond maturity, quality (ratings) and currency.

This breakdown highlights the case for a broader allocation to international bonds, given the Australian bond market is overweight in government, bank and higher credit quality issues, and underweight in long-duration maturities and the industrial sector. In terms of allocation sizes, a good rule of thumb is to follow market size proportions, with Australia accounting for around 2 per cent of global government and credit bond markets.

Bonds perform differently to equities in a portfolio and they potentially offer risk and volatility reduction, which can protect against potential losses to a portfolio when equity markets are in decline.

Manage your currency risk

A very important consideration when investing in overseas bonds is currency risk.

It is generally accepted that hedging currency in international bond exposures is critical to maintaining their risk-and-return properties while allowing global bonds to play the traditional diversification and risk-reduction role that has been the hallmark of high-quality, investment-grade bonds.

This function of hedging is especially important when share prices are falling during periods of market stress.

Align to your goals and adjust over time

Allocations to bonds in portfolios should align closely to investors’ long-term objectives and be adjusted according to their changing risk profile over time.

An investor’s risk profile relates to how comfortable or otherwise they are with levels of risk in the investment mix.

Generally, the higher the expected return of an investment, the higher the risk, so on the spectrum cash follows bonds, follows property, follows shares. And generally risks are lessened the longer the investor’s holding period.

Jeffrey Johnson is head of the fixed income group at Vanguard Asia-Pacific.

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