Traditional Core Bonds Can Anchor Portfolios Through All Market Cycles

Bonds are often assumed to be a quiet constant in an investment portfolio. Most see bonds as an asset class that, at its heart, preserves capital while producing consistent income.

While the universe of potential fixed income securities is in fact vast and varied, a traditional core bond strategy can strike the right balance that most investors are seeking: diversification, rigorous risk management and flexibility. An actively managed core bond allocation has potential to deliver above-average returns through all market and interest rate environments while lowering portfolio risk.

Investors today are monitoring interest rates closely as many developed markets are poised to switch from a stimulatory rate-cutting cycle. Even so, the eventual unwinding of accommodative policy is unlikely to result in a surge in interest rates over the next three to five years. We expect a period of low inflation and low growth as substantial levels of sovereign debt continue to course through global economies. We call this secular phase The New Neutral, and it will naturally constrain central bankers’ monetary policy options in developed economies.

Generating strong investment returns in this environment will be more challenging across most major asset classes, particularly for investors who have enjoyed strong returns in recent times. The Barclays Capital Global Aggregate Bond Index (hedged in Australian dollars) delivered an annualised return of 7.37 per cent, while the Australian benchmark, the Bloomberg AusBond Index, posted 6.45 per cent over the three-year period ended 31 December 2014.

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While bond returns are now expected to be more modest than in the rate-
cutting environment following the global financial crisis, the argument to use a traditional core bond strategy to anchor a portfolio remains compelling.

Core bonds balanced against equity allocations

Many investors retain a significant exposure to Australian shares: More than one-third of adult Australians hold direct shares (according to a recent survey by the Australian Securities Exchange), while the average superannuation retirement fund’s allocation to growth assets remains among the highest of all OECD countries.

Such a high equity allocation leaves many portfolios subject to volatility, which can strike during periods of market uncertainty. Bolstering portfolios with a core allocation to bonds – which have an inherently low correlation to equities – can help smooth out the inevitable impact of such market shocks. This can be particularly important as investors approach retirement or start to draw down on their super, both to preserve capital and to lock in steady income.

While many investors are attracted to the relatively high franked dividends generated by Australian shares (a franked dividend has lower tax implications), bonds produce a more consistent and sustainable income flow without such extreme levels of capital volatility. Bond markets are not immune from ups and downs, but the ride tends to be smoother and the risk of capital erosion is significantly less.

A range of bond sectors

A traditional core bond strategy can include a range of fixed income securities including government, semi-government, corporate, high yield, mortgages, emerging markets and inflation-linked debt. These sectors offer a diverse palette that a skilled active manager can choose from to add significant value – a key goal in the expected lower growth environment that is set to play out in coming years. The value-adding opportunity set can also be dissected by country, industry and company, and a skilled manager will invest in those areas set to grow faster than the wider economy.

Core bonds offer a broad universe that allows Australian investors to tilt their bond portfolios in the direction that emphasises their specific objectives, whether it be achieving a higher yield by climbing the risk-return spectrum, or managing the risk of rising interest rates with a flexible duration approach.

Security selection together with top-down views

Investing in bonds takes equal amounts of skill to select securities (striking the right balance between risk – measured by a bond’s credit quality, among other factors – and return) and to assess the macroeconomic conditions that can drive interest rates and broader market developments.

While the potential for rising rates is an area of concern for bond investors globally, the Australian economy has seen slower growth, with the Reserve Bank of Australia holding rates at low levels.

Our base case is for low policy rates in Australia to continue at least over the cyclical horizon now that the mining boom has cooled and the economy is rebalancing. We estimate The New Neutral rate for Australia to be approximately 3.0 per cent and even a small rise in rates over the medium term would be more than enough to act as a substantial brake on growth and, as such, is an unlikely outcome.

The income, capital preservation, steadier returns and portfolio diversification that bonds can provide will continue to offer value to investors as they navigate through The New Neutral, and a traditional core bond exposure will remain central to that strategy.

This publication is issued by PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862 (PIMCO Australia) and is intended to provide general information only. This publication 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 contained herein is appropriate having regard to their objectives, financial situation and needs. Investors should obtain a copy of the offer document in relation to any financial product mentioned in this publication before making an investment decision.

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