Avoid GFC portfolio outcomes: Beware of Bond naysayers

Beware of the 'bait and switch' scare tactic from Bond naysayers in 2017 or be at risk of similar portfolio outcomes of the last GFC. It is misleading when readers are often shown one-off scenarios about bond markets that, whilst are possible, are so unlikely that it's fanciful to present as a mildly central scenario.

The bond naysayers, in many circumstances, either don’t understand the asset class or are trying to sell you something far riskier (growth assets). In these instances, they forget to mention that the sole role of a defensive allocation to high grade bonds is portfolio insurance which is particularly pertinent in times like these. Notably, for those with limited true-to-label defensive protection against negative risk events or adverse geopolitical ramifications, 2017 is becoming difficult.

Whilst you are unlikely to make your fortune in Australian Government bonds (high grade bonds), they aren’t designed as a growth asset class. As a lower returning investment with extremely low risk over time, they are a favoured place to store wealth. "Make your money in equities and keep it in bonds" goes the popular saying in North America. Many wealthy sophisticated investors store a large proportion of their fortunes in Government bonds because they offer consistent income returns, with principal guaranteed by the Governments. Warren Buffet, considered the world’s greatest investor just reported that Berkshire Hathaway owns billions of dollars in Government bonds.

It's important to remember that Interest rates are the virus that affects all things financial. You cannot have materially higher interest rates without having materially higher funding rates. This situation of magnified stress has a trickle-down (or, in fact, torrent-like) impact in a highly-levered economy. This generally leads to a financial bottle neck or credit crisis.

The only way we could see a material loss scenario in Australian Government/high grade Bonds is with a credit event. In other words, one would be betting that the Australian Government is unable (or decides not) to collect tax revenue from its citizens and essentially goes out of business. That seems a long way from viable.

Ironically, if you are a long-term bond investor, the best long term outcome for you is for Government bonds to sell off continuously, as bonds are an income based product and a sell-off means higher future incomes on offer for a portfolio. If Australian Government bonds sold off for the next 30 years in an exact mirror image of the rally of 1986 to 2016, and you stayed invested throughout that time, you would have cumulative total returns of 677% by 2046. This example is entirely unique to Government Bonds whose rates of return are considered the "risk free rate" in an economy, acknowledging their superior credit quality to bank term deposit whilst also offering investors far superior daily liquidity.

When bombs are dropping or equities are falling, government bond prices tend to perform very well as investors have a "flight to quality" of government-backed revenues. This usually negative correlation to growth assets makes an allocation highly desirable inside a diversified portfolio. High quality bonds come into their own in times of market stress, and act as a counter to a downward revaluation in risk assets.

We urge investors to look for true to label defensive allocations and beware of the ''bait and switch' scare tactic from Bond naysayers in 2017 as it could lead to similar portfolio outcomes as the last GFC.