Government bonds always have a role in diversified portfolios

In the table "Total Market returns for popular asset classes for 2018", JCB team analysis has Aus Govt Bonds' return for the year as 5.1%. Whereas I know people invested in Aus Govt Bond portfolios, either through a fund or a broker, only got over 2% for the year.

Can the author of this article please clarify whether the 5.1% is a return retail investors received, or it is some sort number the industry refers to that only has meanings on the paper? Thank you.

Peter, I'll possibly be addressing that in my column. Most likely the people you have in mind were in a short term bond fund, which did only return 2% especially after fees. 'All maturity' government bond index funds achieved the 5%.

Either that or they were in an actively managed all maturity bond fund that was aggressively in short bonds for strategic reasons and thus missed the capital gains from being at index duration or longer. It was a commonly held view last year that yields were going to increase so you had to be shorter than index.

Look at the websites of the major platforms which offer several different funds in each asset class, and you'll see there was quite a range of returns in domestic fixed interest last year.

Hi Peter,

The 5.1% return for 2018 that I referred to is for the Aus Treasury Bond Index – across all maturities. This index (calculated by Bloomberg) is designed to be representative (in this case) of treasury bonds investible in Aus. For securities to be included in this index, they need to pass a number of rules, such as minimum amount outstanding, and publish ratings from one of S&P, Moody's or Fitch to name some criterion.

This return indeed contrasts with brokers who construct portfolios. These types of broker-led portfolios have tended to be a concentrated and handpicked subset of the broad index. Further, biases in such portfolios will therefore emerge – being deliberately short duration (relative to index) as Warren noted for instance – resulted in a markedly varied result from the market.

Another challenge also for many of these portfolios – broker or managed fund constructed – is the popular tilt towards credit-based debt or even entire off-mandate exposures (such as currency or swaps). Additional yield is great in benign times/declining spreads, but be careful in stressful periods.

These two points (above/combined) also highlight being wary of go-anywhere (e.g. unconstrained) bond managers who have the licence to go essentially anywhere with lower to no transparency – across duration, credit quality and even geographies. There is an argument for allowing specialist managers in each of these segments to manage these individual exposures (e.g. credit, sovereigns, high yield), rather than relying on a single manager to cover the entire market (“jack-of-all trades vs master of none”).

In short, this introduces a set of different risks which investors should be very aware of: these biases can materially affect outcomes which can compromise one’s defensive outcomes over time.

Old-fashioned, plain vanilla duration does have some role to play – in combination with other exposures – in defence. 2018 was a great illustration of the true value of duration in defence in portfolios, especially when times are troubled.

Hoping this helps

Best, Paul

Hmmm. no one will be surprised that I've got some thoughts on this discussion, including some of Ashley's comments.

But I have the luxury of an article due, so I'll make my comments in that.

Pre-reading might include my article on the myth of the 30 year bond bull market: https://cuffelinks.com.au/unpacking-30-year-bull-market-bonds/

All I'll say here is that I wish Peter luck trying to win this argument if his target audience is retail investors in Australia. In my 30 year career managing fixed income I realised very early on that they generally have a longer term view and aren't afraid of the volatility that his argument addresses, or they have a shorter term view and duration risk is a genuine concern for them.

And the fact that overseas investors own more bonds than Australians is simply something they laugh at. "more fool them" would be a typical response to that.

Most interesting discussion, esp. the contrasting views between Ashley and Paul.

I do wonder how we can rely on global sovereign bonds to play their traditional defensive role (esp. US Treasuries) when experienced investors such as Ray Dalio (Bridgewater Associates) have the following to say:

(on Bloomberg 12-09-2018)
"We have to sell a lot of Treasury bonds, and we as Americans will not be able to buy all those treasury bonds," he said. "The Federal Reserve will have to print more money to make up for the deficit, will have to monetize more, and that’ll cause a depreciation in the value of the dollar."

(continued) "Dalio said the U.S. will turn to printing money to fund the deficit because demand for Treasuries won’t meet the nation’s borrowing needs and the government won’t risk choking off growth with higher interest rates. The currency may "easily" weaken by as much as 30 percent, creating a "dollar crisis," he said, though the economic contraction won’t be as sharp or severe as it was after the 2008 financial crisis."

Now, that is for US Treasuries, and we know that in the last 12 months alone the hedging costs against currency risk for this asset was pretty high, lowering what was already a skinny margin. And we haven't touched on bond risks in Europe. (Italy?).

The points raised by Ashley and Phil above, on moving towards an inflationary environment are certainly a concern.

Ultimately the choices seem to be between monetising or austerity. The current political environment in the US would rule out the latter.

Needless to say, as Chimerica unwinds, we watch with great interest as to how the USD's role as a reserve currency plays out and the ensuing downstream effects on investment markets.

The case for holding government bonds as a defensive asset only works when inflation is not high or rising. The argument is based on a selective view of history – ie only looking at the post 1980 disinflation period. Bonds provide a good buffer against share sell-offs ONLY when inflation low or falling.

For example, they provided no buffer at all in years of high or rising inflation – eg 1951, 1952, 1960. 1965, 1970, 1973, 1974, 1976 – in Australia – when bonds had negative returns along with shares.

Or globally: 1969, 1970, 1973, 1977.

Since the recent post-1980 disinflation period is over he should recognise that the great returns from bonds over the last 30 years clearly will not continue.

A good reminder that simply extrapolating the past can be misleading. In my view, we are entering a whole new era of poor bond returns – like 1946-1979, and 1900 to 1921, etc – when gov bonds generated negative real returns for decades at a time.

Since the recent post-1980 disinflation period is over he should recognise that the great returns from bonds over the last 30 years clearly will not continue.

So are you suggesting we are entering a period of rising inflation?

In this expected lower return, higher risk environment (relative to recent trend for most asset classes), being well-diversified and fully invested will be key. The fact is that high grade sovereign bonds are severely under-represented in many investors’ portfolios as mentioned – I wouldn’t have thought the allocation to this exposure should be zero considering the over-weighted and inherent credit risk residing in portfolios. I would argue that high grade sovereign bonds have some role to play to complement other credit-based exposures so dominant in defence.

It’s worth noting that if a hyper-inflationary environment occurred in short order, asset classes such as shares would be severely affected. Granted, bonds would experience some depressed returns, but they would not likely be in the range as experienced in risky assets. And, as an asset class that derives its returns from income (and income on income), over time, they will serve a purpose in portfolios.

High inflation is not a total impossibility from here, but one should consider the range of other outcomes possible given weakening conditions, tightening US monetary policy and enormous debt loads. If inflation does not break out, then positioning portfolios for the other eventualities is prudent.

The returns for “Intl Gov Bonds” in the first table need clarifying. It shows 8.0% for YTD Sep 2018, +5.3% for Q4 2018, and +13.7% for full year 2018.

These are fairly close to the actual returns for Un-hedged Sov. Gov. bonds but all funds that I know of are 100% hedged.

Total returns from AUD Hedged Global Gov Bonds were: +0.0% for YTD Sep 2018, +2.1% for Q4 2018, and +2.1% for full year 2018

So 85% of the returns came from the FX gains from the 10% fall in the AUD over the year, not the bonds themselves.

Investors would have been better off with USD cash which was up 10% for the year with no duration/inflation risk and no credit spread risk.

Re: global sovereign bonds (as shown by the Bloomberg Barclays G7 index), JCB offers an actively managed AUD unhedged version of this – which does NOT derive its returns from having: a) an Emerging Market or EM FX exposure and/or b) credit-based exposures. This offering invests in min investment grade Government, Semi-Government, Agencies, Supranational in a selection of countries primarily focused on the G7, hedged back to USD – which helped investors who sought a liquid USD exposure.

Where credit has performed well in the period since the GFC, now is the time to separate exposures and to be clear on where one’s returns are coming from in a portfolio construction sense.