No one knows what will happen to financial markets in the coming months but it seems likely that growing uncertainty – due to China, higher interest rates in the US, lower oil or something unexpected – will cause increased volatility
Recent well-reported sharp declines in shares and step-like rebounds are likely to be more frequent in future. If you were worried about the value of your portfolio, then it’s a sign that you need to rethink your asset allocation and think about increasing the proportion of defensive assets you hold including deposits and bonds.
While I’ve been advocating bonds for some time now, recent volatility provides an opportunity to compare the two.
Over the week ending Tuesday 25 August, the ASX 200 was down 9.5 per cent.
The best comparable index for bonds is the Australian iTraxx. Over the same week that shares were down, a theoretical five year investment grade bond would have seen its price decline by just 0.6 per cent. This equates to a loss in value of $60 on a $10,000 investment, significantly lower than the 10 per cent move experienced by the average top 200 companies’ shares.
Low risk, investment grade bonds performed as I would have expected them to, they held their value and counter-balanced the risk of shares. Preserving capital is a key reason for including bonds in a portfolio.
Two specific examples of bond prices over the same week are ten year government bonds and the Sydney Airport 2030 inflation linked bond that I suggested a few weeks’ ago.
Government bonds outperformed over the week we are considering. Pre-correction, a government bond maturing in ten years traded at $143, increased to a peak of $146 and closed on Tuesday at $144.50. This bond increased in value when shares were dramatically lower in value, so would have hedged a share portfolio. This is the benefit of Australian government bonds that few retail investors appreciate. Even though interest payments on government bonds are low, the price of them generally moves up on negative sentiment.
The other example, the Sydney Airport 2030 inflation linked bond started trading at $119 at the beginning of the week and ended $4 higher at $123.43. A number of factors contributed to the rise in price of this bond:
- This bond is tied to inflation and pays CPI plus a fixed rate of return of about 3.25 percent. The fixed rate of return is attractive when markets think interest rates could be moving lower
- The long 15-year term to maturity means the price will benefit more than a shorter dated bond from declines in interest rates
- It is a monopoly infrastructure asset with excellent cashflows, so is defensive when you compare it to other companies whose cashflows are influenced by economic conditions
Is now a good time to invest in bonds?
The great thing about bonds is that as long as a company continues to operate or ‘survive’ you will be paid interest, get your capital back at maturity and make a positive return. If your view is that interest rates will be low for a long time, investing in bonds that provide a known, fixed rate of return will be an attractive option.
Inflation linked bonds that are supported by stable monopoly infrastructure assets are great investments in volatile markets. Fixed rate bonds with known returns are also worthy additions. Floating rate bonds are less attractive, but I’d still suggest an allocation just in case interest rates rise.
Buckle in and accept market gyrations or rethink your allocations and increase your bond holdings.
Originally published in The Australian on 28 June 2016
