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MLC Investment Management Investment insight Is it still worth investing in bonds? September 2013 Bond markets reacted quickly in May and June when the US Federal Reserve (the Fed) indicated it would begin winding back its bond-buying economic stimulus program earlier than expected. Bond prices plunged and yields in all the major bond markets rose sharply (the two move in opposite directions). Investors interpreted the Fed’s hints as a sign that interest rates would start moving upwards, driving down bond prices. Kajanga Kulatunga Portfolio Specialist MLC Investment Management Despite short-term market gyrations, bonds play a very important role in a diversified portfolio. Bond markets have continued to be volatile over the last three months. But on balance, the magnitude of the recent sell-off looks overdone: global growth and inflation remain below trend and don’t support rapid interest rate increases. The Fed’s recent announcement that it would not yet wind back the bond purchase program supports this view. Investors holding bonds lose money when bond prices fall (due to interest rates and yields going up). They make money when prices rise (due to yields falling). The recent fall in prices, and rise in yields, has meant short-term negative returns from bonds. As investors tend to see bonds as the stable, reliable part of their portfolio, some have begun to question whether they remain a worthwhile investment. Despite short-term market gyrations, bonds play a very important role in a diversified portfolio. Understanding this, and the contributions of different types of bonds, can help investors take a more long-term view and reassure them that bonds remain a valuable investment. What role do bonds play in a diversified portfolio? Diversification Bonds aren’t generally included in an investment portfolio for the purpose of generating high returns (though they have in fact done this over the last 30 years). Rather, the role of bonds is to increase diversification, as bonds tend to perform well when shares are doing badly and vice versa. So bonds help insulate against the worst kind of market risk − the risk that share markets plunge suddenly and unexpectedly. For example, in 2008, global share markets seemed to be sailing toward another year of gains, while bond prices were experiencing 30-year lows. Why own bonds in an environment like that? Well, because by the end of calendar year 2008, a mixed portfolio of bonds had achieved a 9% positive return, while stocks were losing 25% − meaning bonds outperformed stocks by 34%. A similar drop in share prices and surge in bond returns happened in 2001 and 2002 (see chart 1 on the next page). . Is it still worth investing in bonds? Page 1 MLC Investment Management Is it still worth investing in bonds? Chart 1: Bonds generally perform well when shares fall in value One year returns to 31 December 15.0% 10.0% 11.6% 9.2% 8.3% 5.0% 0.0% -5.0% -10.0% 2001 2002 2008 -9.4% -15.0% -20.0% -25.0% -24.9% -26.9% -30.0% Barclays Global Aggregate Bond Index ($A Hedged) MSCI World (unhedged) Source: MLC Investment Management The stabilising effect of bonds means that over time, investors holding bonds and shares enjoy a smoother ride and experience lower losses in share market downturns than those just holding shares. Although returns on some types of bonds are currently low, especially compared with the strong returns of recent decades, bonds are still likely to help cushion a diversified portfolio against the volatility of share market returns. This alone makes bonds worth holding. Income Another important reason to invest in bonds is the regular income they provide. The interest payments an investor receives on a bond, called coupons, are a fixed amount, rather than being paid at a company’s discretion like dividends on shares. In recent years, low interest rates and yields have made it necessary to look beyond government and even corporate bonds to other bond markets to find higher yields. These markets include US high yield bonds (corporate bonds with a lower credit rating and therefore higher risk) and bank loans (debt of companies rated ‘high yield’). Both held up quite well during the recent bond market sell-off. The two key risks of bonds are interest rate risk – the risk that interest rates will change, affecting the price of the bond – and credit risk, which is the risk that the issuer of the bond will default. The table on the next page shows some of the bonds MLC currently invests in and the role each plays in our bond strategies. Why invest in a range of bonds? MLC’s bond strategies are invested across many types of bonds. Different bonds perform well in different market conditions and have varying risks. By investing across a wide range of bonds, we further diversify both the risks and the sources of return in our portfolios. Is it still worth investing in bonds? Page 2 MLC Investment Management Is it still worth investing in bonds? Investment Cash Includes cash, deposits, bank bills and other short-term securities. The value of the security is mainly linked to movements in short-term interest rates. Australian bonds Investment-grade bonds issued by the governments, semi-government bodies and companies. Global government bonds Sovereign and treasury-issued bonds. Global non-government bonds Investment grade bonds. Issuers include companies and government agencies. Global multi-sector bonds Flexible strategies where managers have discretion to invest in many sectors of the bond market. Global high yield bonds Bonds issued by companies with a credit rating below investment grade. They usually pay higher rates of interest than more creditworthy securities because they have a higher risk of default. Global bank loans A source of funding for companies rated ‘high yield’ to finance their operations and growth. Senior secured debt, in the form of bank loans, is usually the lowest risk part of a company’s capital structure. Australian inflation-linked bonds Similar to conventional bonds except coupon payments are directly linked to inflation. Role in MLC’s bond strategy . Preserving capital, particularly in recessionary and credit crunch environments and when interest rates and inflation are rising. Tend to perform well in environments of falling interest rates and inflation, which means they often provide excellent diversification in negative environments. Similar role to Australian bonds. They also provide a good trade-off between risk and return because their exposure is diversified across many different countries, each with a different interest rate environment. Government bonds perform well in credit crunches. Generally have higher credit risk than global government bonds. They provide a good risk-return trade-off because their exposure is diversified across many different industries, companies and countries. We expect the managers we’ve appointed to have diverse skills to generate returns significantly above traditional bonds. Enables us to capture the expected long-term premium paid for investing in securities with a higher risk of default. High yield bonds tend to perform well in periods of growing credit and global booms. Tend to perform well at times of credit expansion and in However, the concerns surrounding global booms. the emerging economies at present highlight just how uncertain the world remains for investors, and just how vulnerable markets might be in the event that central bank support Provide medium to long-term protection in periods of high in the form of quantitative easing inflation or expected inflation, with some volatility of eventually ends. returns because they are long-term. Returns can be quite soft in periods where markets anticipate very low future levels of inflation. These bonds are used in our diversified portfolios. Is it still worth investing in bonds? Page 3 MLC Investment Management Is it still worth investing in bonds? How are MLC’s bond strategies currently positioned? Since early 2010, we have actively managed the bond strategies in our diversified portfolios to reduce interest rate risk and credit risk. During the recent bout of market volatility and also over the last three years, our bond positions have helped our diversified portfolios generate strong returns (see Chart 2) and provided good diversification when share markets have fallen. . • Our active management of bonds has included: • . lowering interest rate risk by reducing duration in several bond strategies in 2010. In simple terms, duration measures how much a bond's value would rise or fall if interest rates were to fall or rise. Bonds with shorter terms to maturity or higher coupon rates have shorter durations (they’re less sensitive to interest rate risk) than bonds with longer terms to maturity or lower coupon rates. Government bond yields around the world were then (and still are) at historical lows so we reduced exposure to them in our longer duration portfolios. • reducing interest rate risk by increasing our exposure to floating rate securities. These securities have virtually no duration; when interest rates move, the yield on these securities moves with them and the value of the securities doesn’t change. increasing our allocation to both the US high yield bond and bank loan markets across our strategies. These provide higher yields than other bonds and because their primary risk is credit risk, they also help diversify the types of risk in the strategy. Chart 2: MLC Horizon 1 – Bond Portfolio and MLC Diversified Debt Fund have provided strong returns in a volatile environment $14,000 Growth of $10,000 MLC MasterKey Super Fundamentals invested 31 December 2009 $12,996 $13,000 $12,000 $12,189 $11,938 $11,000 $11,454 $10,000 $9,000 $8,000 MLC Horizon 1 - Bond Portfolio MLC Diversified Debt Fund MLC Australian Share Fund MLC Global Share Fund Source: MLC Source: MLC Investment Management Is it still worth investing in bonds? Page 4 MLC Investment Management Is it still worth investing in bonds? Each bond strategy in our diversified portfolios has different exposure to interest rate risk and credit risk. This enables clients with longer investment horizons to take more risk and benefit from higher potential returns. What’s the outlook for interest rates? We think markets have overreacted to the Fed’s recent comments about winding back the bond purchase program. While the US economic recovery is gaining momentum, it doesn’t appear strong enough to accommodate higher borrowing costs, so it’s unlikely interest rates there will rise sharply. A gradual rise is more probable. Both UK and eurozone economies remain weak and we expect rates to remain low there too. Meanwhile, economic indicators in Australia remain soft because of concerns about the sustainability of commodity demand from China, a rise in unemployment and the change in the Federal government. To top it all, Japan has recently begun its own bond purchase program, which may end up being even larger than the Fed’s. All of this points towards interest rates, and bond yields, remaining low for a while. . How are MLC’s bond strategies positioned for likely developments? From an Australian perspective, both the US high yield and bank loan markets show attractive return potential. Our low duration strategy, with exposure to a range of global and domestic bonds (including exposure to non-government bonds) is well positioned for an environment in which interest rates remain low but rise gradually. However, we’re continually looking ahead to how the investment market could develop longer term, and we adjust our strategies if we find ways to reduce possible risks and capture potential returns. And all Fed governors have emphasised that interest rates will remain low beyond any changes to quantitative easing. Important information: This information has been provided by MLC Investments (ABN 30 002 641 661) and MLC Limited (ABN 90 000 000 402) members of the National Australia Bank group of companies, 105–153 Miller Street, North Sydney 2060. This communication contains general information and may constitute general advice. Any advice in this communication has been prepared without taking account of individual objectives, financial situation or needs. It should not be relied upon as a substitute for financial or other specialist advice. Before making any decisions on the basis of this communication, you should consider the appropriateness of its content having regard to your particular investment objectives, financial situation or individual needs. You should obtain a Product Disclosure Statement or other disclosure document relating to any financial product issued by MLC Investments Limited (ABN 30 002 641 661) and MLC Nominees Pty Ltd (ABN 93 002 814 959) as trustee of The Universal Super Scheme (ABN 44 928 361 101), and consider it before making any decision about whether to acquire or continue to hold the product. A copy of the Product Disclosure Statement or other disclosure document is available upon request by phoning the MLC call centre on 132 652 or on our website at mlc.com.au. An investment in any product offered by a member company of the National Australia Bank group of companies does not represent a deposit with or a liability of the National Australia Bank Limited ABN 12 004 044 937 or other member company of the National Australia Bank group and is subject to investment risk including possible delays in repayment and loss of income and capital invested. None of the National Australia Bank Limited, MLC Limited, MLC Investments Limited or other member company in the National Australia Bank group guarantees the capital value, payment of income or performance of any financial product referred to in this publication. Past performance is not indicative of future performance. The value of an investment may rise or fall with the changes in the market. Is it still worth investing in bonds? Page 5