Download Is it Still Worth Investing in Bonds

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.
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