Accumulating more debt
A combination of rate increases and quantitative tightening is a bigger move than it appears on the surface. The global economy has been accumulating more debt since the previous cycle. With 2018 asset performance in hindsight, investors should demand more risk premium for riskier assets and consider allocating to the safer part of the risk spectrum.
The Australian Commonwealth Government Bond index delivered a 5.1 per cent return in 2018. That is 3.6 percentage points above the RBA cash rate and 3.1 percentage points above inflation. This asset class has no currency risk, a AAA credit rating and a six-year duration. Let duration work for you. It’s likely to perform well when the rest of your portfolio suffers and when the riskier part of your portfolio does well, return on government bonds will likely be modest, but hardly in the magnitude of drawdown or with the volatility of much riskier assets.
Since 1992, the Australian Commonwealth Government Bonds index return has averaged 6.7 per cent, or 4.2 per cent above average inflation, with only three negative years out of 26.
Australian government bonds also offer far more superior and reliable daily liquidity than any other fixed income in the Australian market. So far, in any market condition, an investor can transact across the curve in billions of dollars.
One thing that has been puzzling, watching the Australian bond market from offshore for the last decade, has been the severe under allocation of bonds in pension portfolios. According to the 2017 Global Pension Fund study by Willis Towers Watson, Australian superannuation is the fourth largest pool in the world, yet invests only 14 per cent in “bonds”, compared to Canada and the Netherlands which allocate 31 per cent and 50 per cent to bonds respectively.
A reason for such a low allocation could be because Australia has the lowest defined benefits portion. Or perhaps the bond market has only recently become a sizeable choice to invest in, given the supply of bonds since the GFC. Another explanation is that taxation benefits (negative gearing and franking) of owning shares and property do not extend to bonds, making them less appealing.
Regardless, in the late stage of the business cycle that we are in currently, liquidity and credit quality of fixed income play a very important part for investment portfolios, balancing depressed returns of riskier investments, as we observed in 2018.
The problem is even if investors have a bond allocation, they often allocate to an aggregate bond index, when investors should be able to rightfully demand segregation of government bonds from corporate bonds because they bear different risk and liquidity profiles. Corporate bonds trade like equities under stress, but with less liquidity.
Investors need to ask themselves if they have enough defensive assets in their portfolio in 2019. Can your portfolio segregate government bonds from other types of fixed income? Great if you can, but if you can’t, 2019 is a great year to start.
Duangjai (Kate) Samranvedhya is the deputy chief investment officer of Jamieson Coote Bonds