Riding high in a low-yield market – why bonds still matter

In a climate of prolonged economic stagnation, compressed interest rates and persistent low yields, retirees and income-oriented investors are finding it harder than ever to save for their future wealth needs.

Traditionally, risk-averse investors held a diversity of high-quality income-generating assets, such as bank deposits or bonds, which promised steady returns and effective portfolio protection. However, following a decade of flatlining growth, these once ‘gold standard’ assets are failing to deliver sufficient capital returns to support investors’ real spending needs. What’s more, high-yielding equities offer little reprieve for conservative investors, being maximally exposed to market shocks and downside risks. 

Pressed from all corners, low-risk tolerant investors appear to have few places to turn. But have portfolio managers been too quick to dismiss some traditional asset staples?

Money Management sat down with Robert Mead, PIMCO’s Managing Director and Head of Portfolio Management, to explore the unique state of today’s investment market, outlining strategies for income-oriented investors to gain a leading edge in today’s low-yield environment, and why bonds may have received an unfair rap.

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The ‘New Neutral’

A decade on from the biggest financial collapse since the Great Depression, the ability for investors to generate sustainable income from traditional fixed income assets has been severely compromised. PIMCO defines this prevailing low-yield market as the ‘New Neutral’.

In the Australian context, the New Neutral is an “acknowledgment that to reach the RBA’s 2.5 per cent inflation target, the cash rate needs to be well below what would have been considered neutral historically,” Mead said.

According to Mead, the days of high-yield, low-risk income-earning assets may well be a thing of the past.

“At the time of the financial crisis, with the cash rate at 7.25 per cent and the inflation target [between] two to three per cent, investors were earning around five per cent real by taking no risk,” he said. “We’ve moved to a completely different world in terms of how much return you can get taking no risk.” 

“Given the world is highly levered, and given that the domestic economy is not growing strongly, the neutral rates [have] had to come down accordingly to generate an acceptable level of growth,” Mead said.

Don’t write off the bond

Owing to these unique economic conditions, investors today face one of the “most negatively correlated bond and equities markets since the financial crisis”, Mead said.

While a growing school of thought considers current bond yields far too low to provide adequate portfolio protection and stable income, Mead disagrees, believing it more to do with market sentiment than hard evidence. 

“When you dig into the data, including the recent ‘risk-off’ phase, bonds still offer effective portfolio protection,” Mead said. 

Above all else, Mead argues, asset diversification, with a stabilising core of bond investments, remains key to consistent, high-yielding returns. 

“Rather than thinking about asset classes that are too narrowly defined, we need to think about the combination of assets and what that does in terms of risk-adjusted return,” he said.

For Mead, one of the “hidden blessings” of a low-inflation environment is that while the headline yields appear to be low, “the real returns aren’t as bad as they otherwise could be”.

Indeed, “retirees or for anyone approaching retirement should [think] about income in a real sense, rather than nominal,” he said. This, he argues, is critical to determining returns over an average fixed-income investment period.

Beyond the headline

Investors invariably take their cues from the headline yield; however, Mead urges portfolio managers to look beyond this preliminary figure.

“Don’t be afraid of the headline yield,” Mead said. “Headline yield is not expected return; that’s why you see bond funds, year after year, returning much higher absolute returns than the headline yield would suggest.”

While the quality and performance history of the bond are critical criteria for assessing predicted returns, the yield curve over the investment lifecycle remains the optimal indicator of return, Mead argues. 

“When you take into account yield curve shape, for example if you’ve got a steep yield curve and you roll down a yield curve, you can generate returns well above the yield,” Mead said.

When one bears focus on Australian Government bonds or US Treasuries in particular, Mead believes “it’s essentially cherry-picking the lowest risk or risk-free version of the yield available.” 

“To the extent that there’s also credit spread available to be harvested and the yield curve is steep, the expected return will be above the headline yield of the risk-free rate.”

Indeed, undue pessimism in the bond market may see fund managers and investors turning a blind eye to this core staple of income-oriented portfolios.

“It’s not the doomsday return environment that the headline yield would suggest,” Mead said. “You might have a starting yield [of] 1.5 or 2 per cent, [but] end up with an expected return of 5 per cent.”

“When you consider the inflation rate in the low one per cent range, and can identify sources of income that are likely to be four or five per cent nominal or three or four per cent real in real wealth generation — plus the stability of underlying income — [bonds] are actually quite attractive.”

Positives in the New Neutral

The New Neutral is today’s new norm. Finding ways to adapt to protracted low yields and modest capital returns will remain a foremost challenge for income-oriented and risk-averse investors.

“The availability of higher returning, low-risk assets has all but disappeared,” Mead said. Moving forward, investment success “will depend on investors being very selective about how they can replace that return.”

To meet their wealth goals, Mead offers three key considerations for fixed-income investors:

1) Do not expect a mean reversion back to the pre-GFC world: a low-yield, low-interest market will stay with investors for the foreseeable future.

2) Portfolio liquidity will become hugely important for long-term investors. Mead believes the provision of liquidity from the financial sector will be permanently reduced, presenting a clear opportunity for Australian investors. “Illiquidity can be used to investors’ advantage,” Mead said, “with markets willing to pay for liquidity via an illiquidity premium.

3) Finally, he urged investors to maintain strict investment discipline around diversification. “Don’t be too yield-hungry, but think about the combination of different assets in the portfolio and what that does to risk-adjusted returns.”

To learn more about targeted investment strategies for fixed-income and retiree investors, visit PIMCO at www.pimco.com.au

This communication is intended to provide general information only and has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision investors should obtain professional advice and consider whether the information is appropriate having regard to their objectives, financial situation and needs.