Angus Coote

Who calls an electrician to do their plumbing? "Beware the bondcano", "short of the century", "beware the bond market bubble": several of the notable headlines seen in the last few months. Mostly quoting misguided equity investors who have never sold or managed a bond in their lifetimes. For what bond investors think of current markets, see the monthly note from Jamieson Coote Bonds (JCB) below. It’s important to note that JCB do not advocate 100 cents in the dollar allocation to bonds, but zero is like playing Russian roulette with 6 bullets in the chamber. High quality bonds have an enduring role to play in well diversified portfolios over extended periods.

September produced the challenge to status quo in markets we had written about in the August monthly, with increased volatility across all asset classes. Markets continue to grapple with quantitative easing policy and balance sheet expansion and contraction in the central banks of Japan, the US, Europe, and England. To see out the year we also have to contend with the US presidential election, Italian senate referendum - a possible BREXIT moment for Eurozone - and stressed European Banks, led by Deutsche Bank and Commerzbank.

All of these possible event risks would normally drive investors towards the safety and security of Government Bonds, and yet current mainstream newspaper or social media feeds tend to be extremely negative towards bonds. In fact, the ‘’hawkish’’ (higher interest rates) count in global media is something that quantitative analyst Neil Tritton (and our London-based Advisory Board member) monitors, peaking at a 16 year high in September. Bonds may well find a new post BREXIT valuation range, however, to achieve a sustainable sell off would require central banks to materially and consistently lift interest rates.

Globally this looks extremely unlikely after rate cuts this year from Australia, Japan, Europe, New Zealand and Canada. The ‘’bears’’ also tend to forget that the record asset prices we are all enjoying are a direct result of low interest rates, and a sustained lift in interest rates would deliver a brutal deleveraging (as private sector has record debt exposures vs income) which happens much faster than a re-leveraging that we have already experienced. It is hard to see how any central bank would be a material interest rate hiker into collapsing financial asset and property prices.

The other major problem for the bond ‘’bears’’ is time. If you are short or underweight bonds, unless the market sells off immediately, you are paying away ‘’carry or coupon’’, i.e. the interest payments made by the bond’s issuer (in our case, Australian dollar denominated Governments). That carry or coupon is all powerful over time and is the main source of return for this asset class on an indexed basis. An August 2016 study by Bank of America/Merrill Lynch looked at bond returns in a bear market that entirely mirrors the rally of the last 30 odd years. A bloodbath you might think, with bond yields getting higher and higher over that time. However, assuming an investor stayed invested throughout that period, the returns are incredible. German Government Bonds, starting at a negative observable yield, produce a total return in excess of +350%. US Treasury Government Bonds returned more than 400%. Australian Government Bonds were higher again. That discredits the long-term ‘’bear’’ narrative. This major advantage of bond ownership is that carry or income continues to grow as the market sells off. Bonds are entirely unique in this manner: as their price declines the income opportunity set of the asset class grows. When bonds rally, investors are in receipt of ‘income’ (coupon/carry) plus an unrealised capital gain. When bonds prices decline, investors are still in receipt of income, whilst also having an unrealised capital loss. This unrealised loss does not need to ever be crystallised. If you own a bond to maturity, you will receive income during the ownership period, plus return of principal upon maturity. This can then be reinvested at higher interest rates. The critical thing to assess, of course, is the creditworthiness of the bond-issuer - in our case AAA and AA+ rated Governments, to repay upon maturity in the future.

Diverse opinion from buyers and sellers is a hallmark of financial markets. Bulls and bears set the market clearing price and the challenge is to pick the optimal time to buy and sell in all asset classes, whilst at the same time maintaining a balanced asset portfolio that spreads and reduces risk. We always suggest a balanced and diversified portfolio, in which government bonds, with income guaranteed by governments, negative correlation to risky assets and immense liquidity, are an anchor or bedrock allocation. Investor life-cycle and risk tolerance thereafter will dictate the allocation size as a percentage of the portfolio.

We still maintain that AUD bonds are broadly range-bound over the balance of 2016, as the RBA has moved to the sidelines into a pause and assess phase. Unsurprisingly the market has pulled back from BREXIT shock valuations but talk of out and out bear market are premature. That would require sustained Central Bank rate hikes, which are a long way off. However, given the extreme negative sentiment of the media, any ‘’shock’’ could produce a powerful rally, as underweight investor positioning would be seriously challenged. The market is priced the FOMC to raise interest rates once in December and has already discounted this scenario. We would expect bonds to do well on any such move, similar to the powerful bond rally after the singular FOMC hike in December 2015. We continue to tactically position the portfolio around this opportunity set and will continue to manage through the volatility.

Contributed by Jamieson Coote Bonds: (VIEW LINK)


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