Can bonds work in a growth economy?

The global economy might be showing signs of growth but the lower for longer environment prevails in Australia. It might make sense to increase exposure to US dollar investments, Danica Hampton writes.

With interest rates heading higher and the global economy resuming a growth trajectory, it’s clear the investment landscape is changing and your investment portfolio may also have to adapt to the new reality.

Younger investors may never have made decisions in the environment we are heading into, as it’s the first time in more than a decade that the needle has pointed up for interest rates.

And that raises the question, in a rising interest rate environment, is there any reason to buy bonds?

The answer is yes, and the reason is that bonds should always have a role in a diversified portfolio.

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In general, bonds provide income, protect capital and provide diversification. 

However, what may be adjusted is the type of bond exposure held. There are many types of bonds, including treasury bonds, investment grade corporate bonds, high-yield bonds and mortgage-backed bonds, just to name some of the common ones.

Finding out what bond suits your risk appetite requires some advice and homework, and it’s worth taking your time to make sure you get products that meet your portfolio needs.

But perhaps not as well known is that investors can also tilt bond exposures towards sectors that benefit from a rising interest rate environment. For example, the financial sector – banks, insurers, brokers – typically becomes more profitable as interest rates rise, so their bond issues often perform relatively well against this backdrop.  

It is also worth noting, a rising interest environment is not necessarily bad for investment returns. The chart below shows Australian investment returns during past US Federal Reserve tightening cycles.  Over these cycles, Australian corporate bonds have delivered an average return of 7.8 per cent.

But bonds are just one of the investments in a portfolio that may need adjusting as we head into a new world.

It is the returning strength of the global economy as it pivots to growth that is pushing interest rates higher.

And it is the US that’s leading the charge with strong domestic demand and rising employment.  While there is still some uncertainty surrounding President Trump’s fiscal policies, the US economy is forecast to grow modestly above trend over the next two years.

And against a backdrop of solid growth and rising price pressures, the Federal Reserve has started to normalise interest rates.

It’s a different scenario in Australia, where there is still a lower for longer outlook on interest rates, which is being driven by constrained consumer spending and stubbornly high unemployment.

And this discrepancy between the Fed and the RBA on interest rates creates some interesting opportunities for Australian investors. 

Rising US rates will send investment flows into the US, and away from Australia if it stays on hold. That will place downward pressure on the Aussie dollar and strengthen the US dollar.

And so, if you agree with the scenario, it may make sense to increase exposure to US dollar investments.

Also, if growth and interest rates are higher in the US, then US dollar investments might offer a higher return than those in Australia for a comparable level of risk. 

The key take-away is it’s time to open your investment portfolio, and make sure its content suits the prevailing economic environment. 

Danica Hampton is head of investment specialists at Citi Wealth.