Maintain an even keel

Bonds are an essential part of diversifying any long-term investment portfolio.

Bonds are an essential part of diversifying any long-term investment portfolio.

Six months can be a long time in finance. It wasn't so long ago that the smart money was declaring 2012 the year of equities. Bonds, they said, had had a good run. But there was no way they could go any further. The bull market was about to return.

Perhaps not so smart, after all.

During the past two months, bonds have returned a staggering 7.9 per cent while the sharemarket has lost more than 5 per cent.

But, more importantly, bonds are proving a handy buffer against sharemarket volatility, cushioning market falls in a diversified portfolio.

"It's all a bit weird right now," the director of ETF business in Australia for Russell Investments, Amanda Skelly, says. "You'd never recommend anyone put all their money into bonds to chase those sorts of returns, but it shows you need bonds to smooth out volatile sharemarket returns.

"Cash doesn't provide that negative correlation because there is no capital movement."

As the graph shows, bonds have been a great diversifier from shares since the global financial crisis.

When shares have been falling, bonds have done well. And while the opposite is also true, the losses suffered by bonds have been smaller and shorter in duration than those suffered by equities.

In 2011, according to Russell, bonds returned 11.4 per cent shares lost 11 per cent. In 2009, when it appeared the GFC was behind us, shares rose by 37.6 per cent while bonds rose just 1.7 per cent. In the quarter when the GFC hit, the three months to December 2008, government bonds returned more than 11 per cent, while shares lost more than 26 per cent.

Skelly says there have been times, such as in 1994, when market conditions are such that both shares and bonds can fall. But this is uncommon.

She says investors also need to be aware that different types of bonds perform differently. As the graph illustrates, longer-term bonds tend to be more volatile, so more risk-averse investors would be better considering bonds with shorter maturities. "If investors don't want any loss, they'd need to look at the shorter end of the market," she says.

"There are high-quality corporate bonds and even state government bonds [available] and they also offer a bit more opportunity for a higher yield than government bonds. Investors tend to want yield as well as protection."

While bonds may now be reaching the top of their cycle, Skelly says there is so much uncertainty about that it is impossible to make a prediction on where they'll go next. She says the message is more about their diversification benefits than whether there is still scope for big returns.

While retail investors can find it difficult to build a diversified bond portfolio due to the larger minimum investment generally required, companies such as iShares and Russell now offer exchange-traded bond funds that provide an alternative to traditional managed funds. A report by ETF Consulting this week found that while fixed-interest ETFs had experienced a slow start since their launch earlier this year, they are likely to gain popularity.

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