PORTFOLIO POINT: Bonds may deliver lower returns than equities, but this is more than offset by a dramatic reduction in risk – a particularly attractive feature when markets are volatile.
For years, those of us who follow the debt market have argued that Australians are overweight equities (often through very high superannuation fund default portfolio allocations) and it seems prominent financial figures and the press are starting to appreciate the argument.
Dr Ken Henry, special adviser to the prime minister, has indicated that the default allocation to growth assets in Australian superannuation funds (around 70%) is much higher than for their global peers, which mostly hold over 50% of their portfolios in conservative assets like bonds. Henry argues that “average” equity returns are inappropriate for many investors, especially older investors:
Depending upon when they enter the system and when they retire, some fund members will benefit enormously from a portfolio weighted heavily toward equities while others will lose big time ... And nobody knows, in advance, who will win and who will lose.1
David Murray, the former chairman of the Future Fund, agrees with Henry as the following excerpt indicates:
Mr Murray said the heavy weighting to equities by superannuation funds was exposing the nation to dangerous financial instability and the public to excessive risk, and that funds should be giving far greater allocations to fixed income-related investments.2
One of the main drivers for high allocations to equities has been the high returns available. Over long periods, equities do outperform bonds in terms of overall returns and they should because they are much higher risk. The difference in returns between bonds and equities is shown in Figure 1, which compares the All Ordinaries Accumulation Index and the UBS Composite Bond Index (which is dominated by very low risk government bonds). The graph shows that equities are far more volatile than bonds, dipping into negative territory nine times in the past 22 years. While there was the possibility of very high returns, very low and negative returns were also recorded.
The bond index only recorded negative annual returns twice over the same time-span and they were for shorter periods and were less severe. Excluding 1994, bonds generally outperformed when equities underperformed, demonstrating the protective nature of the asset class.
Figure 1: All Ordinaries Accumulation Index v UBS Composite Bond Index
Most investors can sustain a period of low or negative returns, but if you’re reliant on dividend income or need to sell your shares at the low point in the cycle, then it could really eat into the capital value of your portfolio.
Now, I’m not saying sell all of your shares and buy bonds, but work out the minimum capital you need to protect your overall goals and lead the life that you want. This amount should be allocated to cash and bonds. Allocating your portfolio entirely to cash means you miss out on higher returns offered by bonds, so I wouldn’t advise that, especially in this market where interest rates are moving lower.
A simple portfolio allocation rule we use at FIIG is to own your age in bonds and cash or have a maximum 100 minus your age in equities. This guide is easy enough for self-managed superannuation fund individuals to replicate. The lower risk characteristics and surety of known income payments and capital repaid at maturity has significant benefits, which should be more broadly available through superannuation funds.
The Australian government obviously considers superannuation important, so we can all self-fund our retirement and rely less on the government for pensions – a huge and growing bill. But there is no safety net for investors in terms of minimum requirements for funds in portfolio allocations to ensure capital is preserved. It makes sense for default portfolio allocations to change as investors age.
A 65 year old with plans to retire simply cannot afford a 40% decline in capital in their super fund, as was the case during the GFC. Ultimately, high-risk portfolios can lead to losses just as investors want to retire, meaning they have to work longer (if they can), rely on less income in retirement or, in the worst-case scenario, seek government assistance if high-risk strategies backfire.
We would like to see the government set maximum risk, minimum capital preservation standards to protect investors. Otherwise, we may all be paying the price of more people needing assistance in years to come.
Risk and volatility are still present and likely to be evident for years. While the US is showing signs of a shaky recovery, doubts are building regarding Spain’s ability to service its debt. Other European countries are facing political uncertainty and tough austerity measures that will inhibit growth and China has lowered its growth expectations. Australia is in an enviable position, but the government in this week’s budget announced spending cuts, particularly to defence, which may constrain growth. It’s no longer unthinkable that we may be in for a sustained low-growth period, despite government forecasts.
If so, how do you pick high-growth equities and isn’t everyone else looking for the same attributes? I think it’s very difficult to pick high-growth stocks in a low-growth environment. Also, investors should consider that those growth stocks may already be priced as such. Small revisions to profit can mean significant declines in value.
Bond investment is altogether different than equity investment. As a bond is a legal agreement and the company issuing them must make coupon (interest) and principal payments, investors’ primary focus is the ability of the company to survive. It’s much easier to choose a company that you expect to survive, even if they have a couple of consecutive loss years, than one which will grow.
Take Leighton Holdings as an example. It has made some poor tender bids that have cost the company, forcing it to revise profit forecasts twice in the last 12 months. The share price has been on a rollercoaster (see Figure 2, which shows a peak share price of $26.24 in March and a low of $17.32 in September), yet the company has a stack of pending work. It’s easy for an investor to judge that Leighton is likely to survive, but much more difficult to predict if that order book will translate to growth.
Figure 2: Leighton Holdings' share price (year to date)
Over the past 12 months, Leighton’s share price moved 34% from its peak to its low. Over the same period, Leighton’s senior $A bond price peaked at $1.065 and its low was $1.025, showing a price volatility over the same period of just 3.8%. In other words, the share price was around nine times more volatile than the bond price. Much of the bond price movement was due to the decline in interest rates (pushing the price of the bond up as it is a fixed-rate bond that can only reflect changes in interest rates through its price) as opposed to perceptions about changes in the ability of Leighton to meet its commitments.
Is now a good time to invest in bonds? What about bond bubbles?
I tend to think there are opportunities in any market at any time. One of the measures we would use in assessing whether the time is right to enter the market is the performance of the Aussie iTraxx. The iTraxx is a “proxy” for credit spreads in the Australian market. It is an index, not unlike the ASX All Ordinaries Index for equities, and shows five-year credit default swaps (CDS) for the 25 most liquid and highly-traded investment grade Australian entities in the market (each is given an equal weight to derive the index figure). It is important for assessing trends in credit spreads for the broader market.
Generally, the higher the value of the iTraxx, the higher the return to the investor and the higher the perceived risk by the market. Figure 3 shows the value of the iTraxx since January 2001. You can see that spreads are still relatively high compared to pre-GFC spreads of around 50bps.
Figure 3: Australian iTraxx value since January 2001
Australian corporate bonds can be fixed or floating (with the yield on floaters changing quarterly to reflect BBSW) or inflation-linked (where the capital value of the bond increases according to the consumer price index) and with spreads still relatively high by historical standards, we don’t think there is a bond bubble (bond bubbles are typically associated with fixed-rate government bonds) as such in the Australian corporate market. While outright yields and credit spreads have contracted since the start of the year, they still suggest value.
US Treasuries, with very low outright yields could be an example of a bond bubble. Current yields on fixed-rate US Treasuries are a very low 21bps for a two-year maturity, 71bps for five years, and 179bps for 10 years. In comparison, Australian Commonwealth government bonds yield a much higher 265bps for two years, 275bps for five years and 327bps for 10 years.
In summary, bonds provide a consistent return with capital repayment at maturity (in the vast majority of cases), but there are periods where they underperform. The fact remains that bonds are lower risk and display less volatility than equities. The lower return you receive from bonds is more than offset by a dramatic cut in risk and like many overseas superannuation fund managers, we think a higher proportion of bonds is warranted in investment portfolios.
1 “Funds should be more conservative – Henry”, by Clancy Yeates, Sydney Morning Herald, March 17, 2012. See also, “Superannuation funds are overweight on shares, warns Henry”, by David Uren, the Australian, March 17 2012.
2 “Super fund investments are far too risky says David Murray” BY: Michael Sainsbury, The Australian, March 21, 2012
Elizabeth Moran is director of education and fixed income research at FIIG Securities.