Are bonds still a sound differentiator?
- On 15/09/2020
Impact of Pandemic
2020 has seen the end of a bull market that lasted over a decade. As usual, the end came suddenly, and from an unexpected cause – a global pandemic. Apart from the high-flying technology stocks, most markets are in limbo pending arrival of a vaccine to allow social contact and renewed economic activity.
We are now at the start of a global recession and the future remains very uncertain. Although there is some optimism about finding a vaccine, how effective this will be is unknown. COVID-19 is highly contagious and appears to mutate easily. Consequently, it is possible that any vaccine will be like that for influenza, requiring annual doses. Under this scenario, the virus could traverse the world indefinitely.
During periods of economic downturns, superannuation funds and other institutions with diversified investment portfolios historically relied on their fixed interest assets to provide stability and some capital protection. Before the pandemic, interest rates had reached record low levels, and many institutional investors had begun to question the value of government bonds for long-term investing. Some funds had even replaced bonds with infrastructure and property as higher-yielding proxies.
Over the last six months, rates have reduced even further– and there are signs that ultra-low rates will be around for an extended period.
What do experts think?
The future of investment returns is even more uncertain than usual due to the higher risks associated with the pandemic. Each year, Rice Warner surveys the leading superannuation funds, investment managers and asset consultants to capture industry experts’ views on their expectations about asset performance over short and long investment horizons. In the most recent edition of this work, respondents remained surprisingly optimistic on the likely long-term performance of equity and mid-risk asset classes such as infrastructure.
For the growth sectors, the expected (nominal) returns have not changed much since the previous survey 12 months earlier, even though asset prices are at different levels and the future is more uncertain. The consensus looks to a widening of the equity risk premium over the next decade.
In line with falls in interest rates, expectations of the long-term returns that will be achieved by Fixed Income and Cash style assets have reduced. For example, the expected long term (10-year) return on Australian Government bonds and Cash fell over the last year from 3.5% to 1.4% and from 3.0% to 1.6% respectively. While there are a range of factors driving this change, it does imply most now perceive a continuation of the very low Reserve Bank Cash Rate for the foreseeable future.
Fixed income and real returns
While this downward shift is considerable, it is severe when we look at returns after inflation. These changes imply that fixed interest investments will realise a negative real return over the next decade and therefore reduce the purchasing power of investors.
Graph 1 and Graph 2 demonstrate this through charting the prevailing ten-year government bond rate relative to Consumer Price Inflation (CPI) and the difference between these two metrics. It shows that the excess return provided by long-term government bonds over and above inflation has contracted in recent years to the point where it is now negative. This calls into question whether these assets remain “low risk” and “defensive” in nature over the long-term.
Graph 1. Ten-year government bond versus Consumer Price Index
Implications for members
Explaining asset allocation in today’s world is more tricky than normal. The only official risk guide for consumers is the Standard Risk Measure (SRM) which measures the number of expected negative years over a twenty-year period. The SRM is not terribly helpful – it would be better if it were combined with a metric showing the expected return after 20 years too. Further, the SRM for many fixed interest investments could now show several years of negative nominal returns on government bonds, given the large number of negative interest rates globally on these products. This sends the wrong message to consumers about the risks on this asset class.
Yet, despite the changed outlook, in uncertain times short-term asset protection takes on a higher value. Even if bonds pay only 1%, that might still be equal to (or greater than) CPI. Many people (particularly retirees) would be happy with a CPI return if they have capital preservation over the next two years. Is this a bad strategy when we know all real assets are inflated on historical terms and are vulnerable to falls during a deep recession?
In the context of superannuation, where most members have a long-term investment horizon, sustained low returns are worrisome. For conservative members (including many retirees), higher allocations to assets such as fixed income and cash will limit the benefit that they can expect to receive from investment returns, particularly when compounded over a lifetime. In extreme cases, high allocations to defensive assets may mean that the real value of a member’s balance is eroded over time.