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Bonds climb as investors seek security

Q Why have bonds rallied so much? Have corporate bonds rallied as much as govt bonds?

Bonds have rallied because there has been a significant shift in the expectations for interest rate movements, particularly in the United States. The Federal Reserve made it clear in early 2019 that its stance regarding interest rates and balance sheet normalisation was going to be closely linked to market and economic data. Concurrently, European monetary policy normalisation is being hampered by an anaemic growth outlook and ever-present budgetary concerns in core Euro economies such as Italy, not to mention the lingering Brexit uncertainty. Despite these issues, most corporate bonds have rallied along with government bonds. The longer that interest rates remain low and stable, the better the chances that credit spreads continue to tighten.

Q Do corporate and government bonds always outperform during market corrections (as they did during the GFC) or is there a risk that government or corporate bonds too could get caught up in a equities market sell-off?

For the last 30 years, having an exposure to government bonds has been a very effective way to manage portfolio volatility during equity market disruptions. By contrast, corporate bonds have not always provided that same diversification, especially in the non-investment grade sector of the market, because individual companies are more prone to falter or default when economic conditions deteriorate. Therefore, it is possible that weakness in the equity market could be reflected in the performance of some corporate bonds. Importantly, however, corporate bond investors receive significant protection through priority payment of interest and capital and works to limit the volatility of corporate bonds relative to equities.

Q What characteristics should investors look for in a bond fund? Eg. Should the fund include both corporate bonds and government bonds to include relatively safe government bonds?

The most important factor when choosing a bond fund is determining whether the characteristics align with your investment goals. For example, if you require a higher level of income, then perhaps lower-yielding government bonds may be unsuitable to achieve that objective. Similarly, if you are seeking to minimise volatility, a fund with high duration (exposure to changes in interest rates) may not meet expectations despite the high credit quality of the fund holdings. Having some exposure to corporate bonds allows a fund manager to diversify risk across dozens, or even hundreds of issuers, minimising the damage that a default could have on portfolio performance. Finally, it is important to understand whether the fund is linked to a benchmark (which forces it to own certain bonds and maintain a certain duration) or whether the fund manager has some flexibility to invest with a degree of judgment to achieve the best risk-adjusted returns. We believe that a diversified investment grade corporate bond portfolio provides a good balance of income generation and capital protection.

Q Is duration something for investors to consider and why?

Historically, long duration government bonds have helped to reduce portfolio volatility, but with interest rates currently so low, we believe duration needs to be considered much more closely in the current environment. With low interest rates, issuers are incentivised to issue bonds with longer maturity dates, and thus higher duration by definition. On a risk-return basis, a low yield and high duration is a very unfavourable combination. Bonds with these parameters will be more volatile if/when interest rates rise. Similarly, when considering bond funds, it is important to determine the duration of the fund overall, because this will be a clear indicator of how the fund will perform in different interest rate environments.

Q What portion of an investors portfolio could be or should be allocated to bonds?

The answer to this question depends mostly on individual circumstances. Bonds are, by their nature, designed to provide income over time. Therefore, they provide a useful balance to growth assets such as equities. Ultimately, a strong case can be made for having some exposure to bonds over most phases of the investment life cycle. For investors that are more focused on capital growth with a long investment horizon, perhaps a higher equity exposure would make sense. Investors who have shorter investment horizons or value capital preservation might consider a higher fixed income allocation.

Disclaimer: Please note that these are the views of the writer and not necessarily the views of Daintree Capital. This article does not take into account your investment objectives, particular needs or financial situation.