There's been much discussion about recent events in the bond market both globally and in Australia, with even Warren Buffett weighing in on the topic, declaring that the fixed income market is not the place for investors to be these days.
On the surface, it is easy to see why most would agree with the commentary, particularly when Australian government bonds have experienced a mildly negative return over the past six months and Australian shares have delivered positive returns following many years of strong performance.
But before you rush to sell off all your fixed income assets to dive into an all equities portfolio as many are suggesting, perhaps pause and think about the role that bonds play in an investment portfolio and then determine if it still holds relevance to your investment goals and time horizon.
The assumption here is that your portfolio has been constructed with an asset allocation that is compatible with your personal risk tolerance and is sufficiently well diversified to both cushion and capture market movements over a multi-decade horizon.
Firstly, rather than think about bonds only for the headline investment returns that they provide - in which case it would be instinctive to dismiss the utility of bonds in a long-term portfolio – understand that it is an asset class that delivers returns with lower levels of volatility. A negative return for an investment grade portfolio of high quality global bonds hasn't dipped below a 5% loss over the last 30 years, while history has shown that equities can periodically enter bear market territory, described as a fall exceeding 20%, and up to 50% during a period of extreme market volatility, such as the Financial Crisis.
So while many commentators question the soundness of using bonds in a portfolio for return contributions, particularly in portfolios with a longer time horizon, perhaps a better way to view the role of bonds is by focusing on a crucial but sometimes overlooked element of a portfolio: risk.
Like an insurance policy that benefits a policyholder when something goes wrong, longer duration bonds are able to reduce the volatility of a portfolio during a market downturn. Hark back to a year ago when many an investor watched in dismay as the pandemic-induced volatility plunged the ASX 200 almost 40 percent into bear market territory only weeks after a record intraday high.
And although the ASX benchmark index has nearly recovered from the market bottom, history and the benefit of hindsight reminds us that an investment portfolio with the cushion of investment grade bonds would have experienced a smoother ride on the COVID-induced journey we have all been on.
It is timely to take a step back and acknowledge the broader picture of the global economy and financial markets. It is also a time when working with a financial adviser can help provide an alternate, dispassionate view. Because even as economic stimulus and vaccine rollouts continue to build confidence in global markets, the long-term economic impacts of the pandemic are unclear and uncertainty induced volatility remains a certainty. Then consider the risk of not allocating a portion of your portfolio to high quality bonds with the knowledge that ongoing volatility is here to stay.
To further illustrate this risk, recent Vanguard analysis found that in today's low yield environment, portfolios built on a dividend-focused strategy will need to be 100 percent allocated to equities and greatly elevate risk, to meet most income needs in the current low yield environment. For investors close to or already in retirement and at the most conservative phase of their investment risk, taking on significant risk to continue funding their retirement through dividends is unlikely to be in their longer-term best interest.
So what then as we move through this low-interest and low-yield environment?
Consider the adoption of a total returns investment strategy which uses both income and capital growth elements of a portfolio particularly during market volatility periods, as long as the total amount drawn from the portfolio doesn't exceed the sustainable spending rate over the long term.
As we emerge from a global pandemic, we continue to urge investors to stay diversified, tune out the short-term noise, stay the course and maintain a long-term focus.
Robin Bowerman, Vanguard Australia