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Briefly, on the role of government bonds

The recent article by Paul Chin advocated a role for government bonds in a diversified portfolio at all times.

I’m more in the ‘against’ camp than the ‘for’ camp. I disagree that government bonds should always play a role in a diversified portfolio. It’s too long a bow to draw for one of the lowest-yielding asset classes. In another article on government bonds, Jonathan Rochford makes a good point that the cost of gaining this diversification is too great if it has to be obtained by owning an asset class that delivers a low return over time.

The role of government bonds in some portfolios

I advocate holding government bonds if there’s a particular requirement for the security and liquidity and a specific investment need. For example:

  • Insurance companies need funds maturing at various dates in the future, with absolute certainty about the value of the asset that matures
  • Banks need high quality liquid assets to meet unexpected levels of withdrawals and as part of managing their capital adequacy
  • Central banks hold foreign exchange reserves on behalf of their government
  • Super funds that have a reasonable allocation to illiquid assets could hold government bonds to help them to meet redemptions quickly and easily

The sweeping arguments about government bonds don’t specify properly what segment of the market is being analysed. For example, the return quoted in Paul's article of 5.1% contrasted with the experience of some investors who achieved only 2% from the asset class in 2018.

It’s easy to guess how the return difference came about. These are the possibilities:

  • The return quoted in the article was from an ‘all maturities’ index. Investors in a fund that focuses on shorter term, lower duration bonds received a smaller return. For example, a fund limited to securities with maturity not longer than 10 years returned around 1% less than the 'all maturities' market. Shorter maturities were returned lesser. Further, deduct an active management fee and you could easily be as low as 2% for your return last year.

  • Another possibility is that some investors were in an actively-managed 'all maturities' fund in which the manager expected yields to rise during 2018 and so had positioned the fund in shorter term bonds. Such a strategy would miss a chunk of the capital gains on offer.

Owning ‘government bonds’ doesn’t, in itself, deliver the degree of diversification benefits claimed in Paul's essay. The portfolio needed a reasonable holding of longer-term bonds that enjoyed some capital gains. Short-term government bonds really only give downside protection. Of course, in a year in which domestic shares delivered a negative return, even +2% provided some ‘diversification’. But a corporate bond portfolio also did that with better returns over the medium to long term.

A couple of other comments on Paul’s article

Paul’s chart showed returns from global government bonds in 2018 of +13.7%. One comment correctly pointed out that this would have been from unhedged global bonds, therefore most of the return came from currency gains rather than from bonds as such. Currency is also a diversifier and may well be the better diversifier for Australian investors to rely on, than our own government bonds.

Another comment said Paul's argument only works when inflation is falling, claiming that this is why bond returns have been strong for 'the past 30 years'. I'll simply point out here that falling inflation led to lower bond yields which have reduced bond returns, not bolstered them. Lower yields deliver capital gains only in the short term, but ultimately bonds are all about income. The last 30-year period started with high yields and high returns, but that was because of high inflation in the 1970s, not because of falling inflation in the 1990s and since.

In any case, you don’t need to create stories about the macroenvironment to predict that Australian government bond returns will be low over the next several years at least. We know it from their yields. The 5- to 10-year Commonwealth bonds are now paying investors only around 2%. So, over the next 5-10 years, that will be their average annual return. If yields do rise, then those returns will gradually increase as well.

 

Warren Bird is Executive Director of Uniting Financial Services, a division of the Uniting Church (NSW & ACT). He has 30 years’ experience in fixed income investing. He also serves as an Independent Member of the GESB Investment Committee. These are Warren’s personal views and don’t necessarily reflect those of any organisation for which he works.

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