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Government bonds always have a role in diversified portfolios

The December 2018 quarter reminded investors of the importance of considering risk when constructing portfolios. Questions remain on a possible global growth slowdown and how asset classes will perform. It is an opportune time to revisit portfolios and fortify them against this sobering outlook with government bonds such as highly rated and liquid sovereign bonds, state-based or agency debt (minimum rating AA) or supranational paper (e.g. World Bank issuing in A$).

The investment context

For much of the calendar year to September 2018, adding risk exposures such as shares and property which leveraged easy monetary conditions performed strongly, as shown below. Simultaneously, many questioned the merit of holding high-grade government bonds (‘high grade’) given apparently higher returning or higher yielding credit-based alternatives.

In fact, over 2018, Australian high grade topped the return charts but, more importantly, played their defensive role, cushioning against negative share markets, providing principal and income stability and delivering liquidity.

Total market returns for popular asset classes for 2018

Source: JCB team analysis, Bloomberg to Dec 2018.[i]

Deep in a late-cycle environment, beware credit-based exposures

The world has continued to lurch even deeper into late-cycle, magnifying financial system risks. The easy conditions (record low policy rates, readily available credit, U.S. stimulatory one-off tax cuts and repatriation) are being reversed by tightening monetary policies worldwide. For investors, these changes have profound implications for defensive ‘income’ exposures in an anticipated lower forward-return environment:

  • Asset class returns since 2009 have been inflated by the distortional policies. A return to properly-calibrated market risk means returns will likely revert closer to (or lower than) trend partnered with bouts of volatility. In this late-cycle stage, investors should be mindful of being compensated for the risks they are taking.

  • Corporates have enjoyed a strong run since the GFC driven by low rates and share buybacks. However, the debt levels they have assumed are enormous at ~US$9 trillion (a +64% increase since 2009). Now they face the hurdle of rolling over debt into a hiking rate cycle. According to S&P Global Ratings (August 2018), investment-grade corporate credit will need to refinance about US$600 billion in 2019, ballooning to over $660 billion in 2020 and to $700 billion in 2021.

  • With around half of all U.S. investment-grade debt rated BBB (i.e. one notch above junk, see below), we question the quality of these assets and the risk of default. The financial system interconnectedness (such as the sources of wholesale funding needed by the large Australian financial institutions) has global implications.

US corporate bonds market capitalisation by credit rating

Click to enlarge

Source: JCB team analysis, Bloomberg.

  • Credit-based debt is in danger of suffering material and sustained underperformance in a time of tighter lending, less liquidity and ultimately growing corporate defaults. In stressful periods, credit-based exposures have behaved less defensively and more like equities as demonstrated during 2007-2009. The venerable Norwegian sovereign wealth fund, Norges Bank IM, underlined that holding corporate credit amplifies portfolio risk when substantial equity positions are already held. With credit spreads having already tightened in this late-cycle stage, credit-based holdings are not compensating investors for the risks in holding this exposure. This is notable considering the clear dominance of equity holdings in many Australian portfolios.

How do high grade bonds differ from other bonds?

Australian investors are, on average, significantly underweight bonds and, in particular, high grade bonds. Willis Towers Watson’s annual Global Pensions Asset Study in February 2018 reported that bond allocations for Australians are small in absolute terms (14%) and low in contrast to other major developed economies, including US (21%), Canada (31%), Japan (56%), Netherlands (50%), Switzerland (34%), U.K. (35%).

The bond allocations as shown below tend to be dominated by credit (corporate debt, hybrids, floating rate notes) and securitised (asset/mortgage-backed) debt which offer a higher yield but come with lower liquidity in times of stress and risks of default.

In contrast, high grade bonds are backed by AAA-rated (or at least AA) issuers such as governments (Commonwealth or state/territory) which is reflective of a relatively solid financial position and an outlook that remains strong versus other developed market countries. The willingness and ability to continue to meet their ongoing obligations should not be an issue.

Not all bond instruments are built or perform the same across different market conditions.

The defensive instrument hierarchy

Source: JCB team analysis.

High grade bonds uniquely defend portfolios

High grade bonds can dampen share market volatility in a diversified portfolio by:

1. Providing principal and income stability

The sheer strength of the issuer combines with the macro tools available, such as the ability to raise revenues through taxation, reduce spending and issue more currency. Principal and income stability is generally solid for highly-rated governments, delivering principal and income stability for this asset class. This design means that high grade bonds represent something different other than financial sector risk which is embedded in other assets so common in Australian portfolios.

It’s also a key reason why high-grade bonds have historically played an effective role in offsetting weak real (i.e. after inflation has been accounted for) share market performance, as shown below. This has been the case for extended periods, inclusive of varying inflationary and economic periods. Since 1977, there has only been one year where both real returns on shares and Australian Commonwealth Government Bonds (ACGB) have both been negative.

Real returns by year, shares versus government bonds, 1977-2018

Click to enlarge

Source: JCB team analysis, Bloomberg data.

2. Performing in a rising rate environment over time

Compared to shares, high grade bonds are self-rebalancing and are an asset class that derives the majority of its returns from income, and the income earned on its income. A hiking rate cycle (lower bond prices) leads to maturing bonds and coupons being re-invested at higher rates. Nearer-term returns may be modestly dampened but, over time, holders of this exposure greatly benefit from compounding.

Contrast this to the experience of corporate debt: a rising yield backdrop would increase the stress on the firm as a dramatically-falling bond price would tend to indicate financial woes. To make good on their coupon obligations, the firm would need to grow income (as they do not have access to the same macro tools governments have) while managing financial stress.

3. Delivering portfolio liquidity

The underlying securities attract major offshore investor interest (over 60% of investors in ACGB are from overseas given relatively attractive yields). Term deposits have the investor locked into terms and redeeming early generally results in penalties.

Closing thoughts

Liquidity and asset quality in defensive assets play a key part in effectively mitigating portfolio risk. High grade provide stable principal and income returns and protection against cyclical downturns. They should play a core role in partnership with other defensive assets across the spectrum such as credit and cash.

The challenge is to right-size the allocation so that investors can secure better portfolio control and be clear on sources of return between high grade bond and credit exposures. In the current late-cycle environment where Quantitative Easing is converting to Quantitative Tightening, returns previously enjoyed will become more modest. It is time to shore up defences with high quality and liquid assets.

 

Paul Chin leads investment research at Jamieson Coote Bonds (JCB) and serves on a number of investment committees including asset allocation and manager selection. This article is for general information and does not consider the circumstances of any individual.

[i] Notes to return calculations: Aus Shares: S&P/ASX 300; Aus Shares Industrials: S&P/ASX Industrials; Aus Shares Resources: S&P/ASX 300 Resources; Intl Shares ex Aus: MSCI World ex Aus in A$; Intl Shares – US: S&P 500; Intl Shares – EM: MSCI Emerging Markets in A$; Aus Listed Property Securities: S&P/ASX 300 Listed Property Securities Index; Intl Listed Property Securities: FTSE EPRA NAREIT DM; Global Infrastructure: S&P Global Infrastructure; Aus Gov Bonds: Bloomberg Ausbond Treasury Bond Index; Intl Govt Bonds: Bloomberg Barclays G7 Index hedged to USD in A$; Aus Cash: Bloomberg Ausbond Bank Bill Index. Past performance is not an indicator of future performance.

 

10 Comments
Peter
February 03, 2019

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.

Warren Bird
February 04, 2019

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.

Paul
February 12, 2019

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

Warren Bird
February 02, 2019

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.

John
February 01, 2019

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.

Ashley
January 31, 2019

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.

Phil
January 31, 2019

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?

Paul
January 31, 2019

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.

Ashley
January 31, 2019

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.

Paul
January 31, 2019

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.

 

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