Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 291

Why bother investing in government bonds?

At this time of year, many investors look back on the returns achieved in various asset classes in the previous year and reconsider their asset allocations. In 2018, Australian government bonds (+5.2%) soundly beat the ASX Accumulation Index (-2.8%). The gains for government bonds were driven by yields falling, with the five-year Australian government bond yield now a miserly 1.84%. This is below the latest reading of consumer price inflation at 1.9%.

Experienced investors know that switching their sector allocation to last year’s winners is a recipe for underperformance, and a contrarian approach is much more likely to deliver outperformance. Given all this, is it now time to sell out of government bonds? What alternatives do investors have for the low risk allocation within their portfolio?

Three common reasons for owning government bonds

The most common reason given for making an allocation to government bonds is the expectation of a negative correlation in returns when riskier asset classes fall. This expectation is based on good historical experience. In times when equities have materially fallen, government bonds have typically delivered solid gains. If an investor is running a 60/40 equities/bonds portfolio, the gains from bonds are expected to provide a decent offset if equities enter a bear market (>20% fall). Many Australian investors with superannuation balanced fund allocations have less than 10% invested in government bonds. For these investors, the hoped-for bump from government bonds in a downturn will do little to offset the losses taken on the 80%+ of the portfolio invested in equity-like assets.

Based on current yields, this portfolio protection expectation comes at a substantial cost to long-term returns. Current yields provide limited room for bond yields to fall further, meaning the upside for bonds in a downturn is unlikely to be substantial. In effect, government bond investors are paying a high annual premium for insurance that is likely to have a limited payoff in a downturn.

A second reason for allocating to government bonds is their perceived low risk status. For countries like Australia and New Zealand, with relatively low debt to GDP ratios, this perception is reasonable. But for countries like Japan and Italy, there is material credit risk embedded in their government bonds. These countries have a long history of running deficits, rising debt to GDP ratios, poor demographics and no meaningful plan to ever reduce their debts.

When the next downturn occurs, there’s a reasonable probability that investors bailout of these government bonds with debt defaults or restructurings required. Even the low risk perception of US government bonds is questionable after a decade of both major political parties supporting very high deficits. If the US government can’t balance its budget now with a booming economy, will it ever be able to?

A third reason put forward for holding government bonds is their liquidity during times of crisis. However, this is an apples and oranges comparison. The proponents are arguing that government bonds are more liquid than shares, property and credit investments, all of which have much higher expected returns. A fairer comparison is to bank bills or term deposits. These have higher yields than a five-year Australian government bond and also have good liquidity from their short-dated investment terms. If the investment fees charged by a typical bond manager are included, the yield shortfall on government bonds is even higher.

Alternatives to government bonds

The merit of various alternatives to government bonds will vary, depending on the investor classification and their liquidity requirements. For investors classified as non-institutional (retail, SMSFs, not-for-profits, family offices), blackboard special term deposit rates of up to 2.75% are available. Building a ladder of maturities allows for a regular return of capital, maintaining good liquidity. Some online savings accounts have even higher rates, but these are often limited to smaller balances.

Investment TypeSuitable ForCurrent YieldMaturityLiquidity
Term DepositsNon-Institutional2.00-2.75%1-60 monthsBuild a ladder of maturities for portfolio liquidity
Bank Bills/ Commercial PaperInstitutional2.00-2.80%1 day-12 monthsVery good daily liquidity
AAA RMBSInstitutional3.40-4.00%1.8-3.0 yearsCurrently good, will reduce in a downturn

For institutional investors that cannot access regular term deposit rates, the primary alternatives are overnight accounts, bank bills and commercial paper. One-month bank bills are currently paying 2.02%, with commercial paper paying a premium on top of this to account for the small amount of credit risk involved. Unlike term deposits, bank bills and commercial paper can be traded on a same day settlement basis. Short dated, AAA-rated, senior tranches of securitisation transactions yield around 2.80%. These typically have a weighted average life of 1-5 months.

Institutional investors looking for higher yields but with a similar credit risk and maturity profile to government bonds can also consider AAA-rated residential mortgage backed securities (RMBS). These typically come with a weighted average life of 1.8-3.0 years and yields of 3.4%-4.0%. Liquidity on these instruments is currently good, but this will reduce if there is a downturn. RMBS is a good alternative to government bonds for investors looking at medium- and long-term holding periods. They won’t provide an offset to equity losses in a downturn, but they can come with a yield of more than double that of government bonds. Based on the current starting position, AAA-rated RMBS returns will easily beat government bonds in a solid majority of years and over the medium and long term, without adding credit risk.


Jonathan Rochford, CFA, is Portfolio Manager for Narrow Road Capital. This article has been prepared for educational purposes and is in no way meant to be a substitute for professional and tailored financial advice.

February 01, 2019

Hi Bob - thank you for your comments and questions.

The key reason for outperformance in the medium and long term and the majority of years, but not every year, is the volatility of government bonds. The unusually strong return for government bonds in 2018 saw it beat AAA RMBS. However, this isn't likely to be repeated as it came from yields falling closer to zero. Government bonds are far more volatile than AAA RMBS on a month to month basis.

AAA RMBS carries a higher credit rating than Queensland, Western Australia, South Australia, Tasmania and the Northern Territory. This indicates lower credit risk. It has the same credit rating as Australia, NSW and Victoria.

Based on historical returns for equities and current debt yields, you would need a 50/50 Australian equities/Australian government bond portfolio to match the AAA RMBS I'm investing in. This is a huge increase in drawdown/loss risk to achieve the same return and will be far more volatile on a month to month basis.

Stanley McDonald
February 01, 2019

To support the case that "last year's winner is a recipe for under performance" you refer to Black Rock U.S. data for the period 1991 to 2010. The data in the Morningstar (Australian) Gameboard for the more recent 1999-2018 period, shown in Graham Hand's introduction, actually shows regular instances that do not support the argument. Why?

February 02, 2019

Hi Stanley - thank you for the question.

The Blackrock study tracked actual returns from allocating to winners versus allocating to losers, simulating what I suggested. The Morningstar chart does show some asset classes winning in consecutive years, but it doesn't have a return over the entire period from following a winners or losers strategy.

Bob Martin
January 31, 2019

Hi Jonathan,

I'm going to have to take issue with your final sentence, suggesting RMBS does not come with credit risk. (hello to the year 2007).

You state that RMBS returns will beat gov bonds in a "majority" of years, without adding credit risk.

Can I ask, if they only beat gov bonds in a "majority" of years, and not "all" years, does that not imply they are adding credit risk, and in the majority of years you are simply being rewarded for taking on this additional credit risk, but sometimes this very real risk means you underperform more conservative allocations like government debt? Could you not achieve the same return outcome from RMBS more cost effectively, and more efficiently (as measured by financial risk metrics) by simply holding a portfolio of say 90% government debt, 10% equities? (or whatever other equivalent % sees you end up at a similar point along along the frontier).

Honestly, if you can prove that holding this kind of credit produces greater risk adjusted returns than simply a weight of gov debt and straight equities .. I will sign up to whatever program you're selling.

Can we agree, the reason they (most definitely) will under perform in some of the "majority" of years is primarily because of credit risk yes?


Leave a Comment:



RMBS today: rising rate-linked income with capital preservation

How active bond funds hunt for value in fixed income


Most viewed in recent weeks

How to enjoy your retirement

Amid thousands of comments, tips include developing interests to keep occupied, planning in advance to have enough money, staying connected with friends and communities ... should you defer retirement or just do it?

Results from our retirement experiences survey

Retirement is a good experience if you plan for it and manage your time, but freedom from money worries is key. Many retirees enjoy managing their money but SMSFs are not for everyone. Each retirement is different.

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Fear is good if you are not part of the herd

If you feel fear when the market loses its head, you become part of the herd. Develop habits to embrace the fear. Identify the cause, decide if you need to take action and own the result without looking back. 

Latest Updates


The paradox of investment cycles

Now we're captivated by inflation and higher rates but only a year ago, investors were certain of the supremacy of US companies, the benign nature of inflation and the remoteness of tighter monetary policy.


Reporting Season will show cost control and pricing power

Companies have been slow to update guidance and we have yet to see the impact of inflation expectations in earnings and outlooks. Companies need to insulate costs from inflation while enjoying an uptick in revenue.


The early signals for August company earnings

Weaker share prices may have already discounted some bad news, but cost inflation is creating wide divergences inside and across sectors. Early results show some companies are strong enough to resist sector falls.


The compelling 20-year flight of SYD into private hands

In 2002, the share price of the company that became Sydney Airport (SYD) hit 80 cents from the $2 IPO price. After 20 years of astute investment driving revenue increases, it sold to private hands for $8.75 in 2022.

Investment strategies

Ethical investing responding to some short-term challenges

There are significant differences in the sector weightings of an ethical fund versus an index, and while this has caused some short-term headwinds recently, the tailwinds are expected to blow over the long term.

Investment strategies

If you are new to investing, avoid these 10 common mistakes

Many new investors make common mistakes while learning about markets. Losses are inevitable. Newbies should read more and develop a long-term focus while avoiding big mistakes and not aiming to be brilliant.

Investment strategies

RMBS today: rising rate-linked income with capital preservation

Lenders use Residential Mortgage-Backed Securities to finance mortgages and RMBS are available to retail investors through fund structures. They come with many layers of protection beyond movements in house prices. 



© 2022 Morningstar, Inc. All rights reserved.

The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.