Is it time to put the brakes on bonds?

Bonds have managed to outstrip equity performance during the share market downturn, but economic conditions have experts cautioning investors that the bond safe haven may not last much longer.

Bond funds management group Pimco says that over the past three year period to May 2003, Australian bonds have returned over eight per cent for investors, while global bonds hedged in Australian dollars have returned nearly 10 per cent.

Pimco executive vice-president John Wilson says those invested in global and domestic shares “can only look with envy” at these performance figures through the period in which equity values have languished.

However, Wilson warns that this abundance of value in bonds may be coming to an end.

“The rational investor has to ask ‘will this persist?’ You’d have to say no,” he says.

Wilson even suggests the bond market has been suffering from bubble-like conditions, though nothing like that of the equity market in 1999 and 2000.

“When a bond manager has the world’s largest mutual fund at $70 billion, you have to wonder if there is a bubble,” Wilson says.

Citigroup Asset Managementchief economist Brian Parker says that over the last few months, there were a number of times when it could have been said there were bubble-like conditions, particularly in the US Government bond market.

“However, we have seen a bit of a pull back from those investments when there was not much sense in the buying,” Parker says.

Parker says that although bond investors have done well, outstripping domestic and global equity funds in the last couple of years, he expects yields now to fall in line with cash.

“Frankly, there is not a lot of longer term value on offer,” he says.

INGresearch manager Gavin Shepherd also cautions against expecting the historically competitive returns from fixed interest investments to continue.

“Investors should be aware that while fixed interest exposure has outperformed recently, this will not always be the case.

“Going forward, interest rates are likely to remain low and the historical returns are unlikely to be repeated,” he says.

Parker says investors need to be aware that as the global economy bounces back and continues to improve the US Federal Reserve may begin to raise interest rates causing capital losses within bond portfolios.

“Investors need to be quite cautious about fixed income holdings, as over the next year or two they face a period of capital losses as yields rise,” he says.

With this general pessimism, are bonds still a good bet?

“Taking a medium to long-term view, clearly if you are a more conservative investor you would still want to hold a higher weighting in bonds or fixed interest,” Parker says.

Wilson says that retail investors have never shown much appetite for bonds because they aren’t well understood.

“Let’s face it. Bonds aren’t that sexy. They don’t fire the imagination the way equities do,” Wilson says.

Sealcorp senior technical manager Terri Ho says that bonds have a place for diversification overall, as well as for specific types of investors who can use them to their advantage.

For example, Ho says insurance bonds have a place for high-net-worth investors because tax on them is paid at 30 per cent, and those on a marginal tax rate of higher than 30 per cent can gain a tax advantage.

Similarly, she says those who are investing for a minor, usually at a marginal tax rate of 47 per cent, can also take advantage of a 30 per cent rate through bonds.

Ho says the planners she is dealing with are still recommending a diversified portfolio to investors, and that older clients, especially those on an allocated pension, feel safer with some money in fixed interest investments.

Wilson says bonds suit these type of investors who are looking to create an income stream that is fairly predictable, with a low risk to capital.

At this juncture of the market, Pimco says the uncertain economic outlook may favour corporate bonds over equities as they have historically outperformed equities during the early stages of economic recovery.

The group says this is because inflation rates typically remain low, supporting bond prices, and companies cut costs and pay down debt, which improves their creditworthiness and corporate bond prices can rise as a result, improving total returns.

Wilson says that as well as good yields still being available on corporate bonds around the world, there are also opportunities in emerging economies and possibly in Europe.

However, ING’s Shepherd says that one thing investors need to watch for is that corporate bonds have been replacing government bonds in bond funds at a rapid rate, exposing investors to the credit risk of the issuer.

“In the last few years Australian fund managers have increased their exposure to corporate bonds in their fixed interest funds and fixed interest component of diversified funds,” Shepherd says.

“As a result they are taking on greater credit risk and are employing credit specialists in their team. Increasingly, investors are being exposed not only to the risk of interest rate movements but also to the credit risk of the issuer.

“Currently most fund managers are moving towards a new international bond benchmark comprised of approximately 60 per cent corporate bonds and 35 per cent government bonds,” Shepherd says.

Parker says that the situation is a case for diversification among asset classes as well as the bond market, given that there are signs now of better equity performance and corporate bonds could help increase yields within bond portfolios.