Even though investment markets are unpredictable, there’s usually at least one asset class that stands out as representing good value at any one time. But right now, many experienced advisers are finding that’s a very hard pick.
Some equity markets have reached all-time highs, residential property prices have continued to climb and bond yields have again dropped to historically low levels. Valuations everywhere appear full.
Even investors who fervently believe that bonds are a sound long-term investment have concerns around the low level of some sovereign bond rates.
This leaves advisers in a predicament. Their defensive clients, including retirees, pre-retirees and self-managed superannuation fund investors, still expect returns of around 7 per cent per annum but they’re not prepared to take on additional risk; meanwhile, real returns from cash are close to zero.
For advisers who have invested their clients in well-diversified portfolios to meet their needs and objectives, the best advice could be to maintain exposure to both growth and defensive assets.
Interest rates lower for longer
The performance of global bonds in the past year surprised many investors on the upside.
A little over a year ago, as the US Federal Reserve signaled that its bond purchases would soon end and as this “taper talk” began, bond prices plunged and volatility spiked in global markets. But contrary to market expectations, the bond market has recovered, and over the past 12 months through June, global bonds hedged to the Australian dollar delivered returns close to 8 per cent, according to the Barclays Global Aggregate Index. Notwithstanding last year’s volatility, the index produced an annual return of more than 7.5 per cent for the three years to June 30, and actively managed portfolios may have done even better.
This better-than-expected performance has made some fixed income investors nervous lately. They’re questioning whether to pull back their exposure to the asset class given its strong run.
Although most investors recognise a repeat performance is unlikely in the short-to-medium term, there’s still a compelling case to maintain a strategic allocation to bonds.
In our view, interest rates are likely to remain lower for longer. We believe the global debt overhang will constrain central banks’ ability to raise interest rates and global economies are likely to converge to modest trend growth rates with low inflation – an environment we call The New Neutral.
As a result, we do not expect the RBA to hike rates for an extended period, which has significant implications for investors. In Australia, we are accustomed to relatively high returns from simply holding very low-risk assets such as cash and bank term deposits, but lower risk-free returns will become part of the local investment landscape for some years to come.
Stable and diversified
Bonds can provide an attractive alternative to cash and term deposits. And with interest rates remaining lower for longer, bonds should also continue to provide a stable and diversified source of return in a portfolio in the coming years. Bonds, then, still represent a compelling opportunity.
Overall, we believe that bond market as well as equity market returns will be modest in the next few years, but even a modest return of between 4-6 per cent would be a solid outcome in the current environment, and certainly a better result than term deposits and cash.
It’s important to remember that bonds remain a key part of an investor’s asset allocation; they continue to offer consistent income, capital preservation, steadier returns than higher-risk assets such as stocks, and diversification, which can potentially increase returns and reduce risk within a portfolio.
For clients with prudent asset allocations designed to meet their lifestyle needs and goals, staying the course may be sound advice.
