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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.

4 Comments

Jonathan

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?

Jonathan

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?


 

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