Smart Investor portfolio report: cash and bonds

Smart Investor portfolio supplement, August 2011

Earlier this year, the consultants Towers Watson put out a survey of global pension assets – superannuation, to us – showing which asset classes are popular in which countries. Bonds occupy a big chunk in most countries: a whopping 56% in Japan and 50% in the Netherlands; 35% in Switzerland and the UK; 27% in the US; and 33%, on average, for the world. How about Australia? Just 14%.

Why don’t we like bonds in this country? It wasn’t always like this: Peter Dorrian, head of global wealth management for Australia at Pimco, one of the world’s pre-eminent bond managers, reckons that when he started out the figure would have been more like 25-30%. He thinks there have been specific drivers – such as dividend imputation rules, which make high-dividend stocks more valuable for super funds, and the received wisdom that it is better to be exposed to growth assets when in the accumulation phase of life before retirement. But more than anything, it reflects the fact that Australians love shares, and that when they want security, they often go to plain old cash (12% of Australian assets, the highest level of any country in the survey).

Bond managers argue we’re missing out. “I’m a great believer in the well diversified portfolio,” says Dorrian. “For most investors who don’t have the confidence or the ability to time their entry or exit in the markets, maintaining a portfolio that becomes more defensive as your need for greater stability of capital becomes more important to you is the secret.” And bonds are seen as a key diversifier in individual portfolios: they stay steady when all else around them is anything but.

Exactly how investors should use cash and fixed income depends on their circumstances. “It depends on each investor’s time horizon, what stage of life they are in, and whether they need to accumulate or start to draw down,” he says. “We would suggest for most investors who are approaching, or in, retirement, a minimum allocation of around the 30% mark. That will give them some comfort about how the portfolio will perform over time.”

The global financial crisis provided some hard lessons about the merits of fixed income. “In 2008, there was a terrible see-saw environment for a lot of people; they saw no end to the carnage in the equity markets, and too many had too great a concentration of equities in the portfolio,” says Dorrian. “If you had a portfolio of 50-50, yes you would have been losing money in the equity component, but you would have been making money in the fixed income component.”

It should be said, though, that not all fixed income behaves in the same way – and another hard lesson of the GFC was that lots of things that are marketed or characterised as plain old bonds are really nothing of the sort.

Fixed income covers a wide range of investments. One could argue that one extreme is cash sitting in the bank: it’s still, after all, a process of you lending money and getting a return on it. Next come Australian government bonds, considered as safe as any in the world, and paying an accordingly low yield. Next, there are many managed funds that will put you into a wider range of Australian bonds, from government to corporate bonds – they’re a little riskier, but pay more accordingly. Still other funds invest exclusively in high yield: lower rated companies. As the risk rises, the yield does too – but also the chance of a default. Then there are products that invest in structured debt, and it was in this camp that the biggest problems developed in the financial crisis: products linked to, for example, collateralised debt obligations, which pile together a number of securities into a single pool, then offer bonds that are exposed to them and which reduce their yield (or are eventually wiped out) if the underlying securities default. While some of these did OK in the crisis, a related problem was liquidity: in many cases people could not get their money out when they wanted to.

Alongside domestic products, there are also international bond funds available, again ranging from top-ranked government-backed bonds to high yield and credit.

Planners vary on their attitudes to these different classes; in the risk article, for example, Darren Johns of Align Financial argues that risk budget should be spent on equities with limitless potential upside, rather than on high yield bonds that might bring in another 1 or 2% but at greater risk. Others think that high yield debt represents a great opportunity, particularly in Asia, where strong but emerging economies are paying a decent rate of interest.

Dorrian, for his part, thinks that when it comes to working out which segment of the debt markets looks best, “we would argue people should be leaving that to the manager. If you’re trying to time your entry in and out of sectors, you have to spend most of your life reading every financial publication that exists, and liquidity can be an issue. It’s much better to put that to a professional manager.” Pimco’s professional view is that it is concerned about many developed market government bonds, because so much debt is accumulating in places like Europe and the US, and it is instead heavily favouring emerging markets, which are in a much better fiscal position than countries in the west.

Australia is a curious market for debt, because in market terms, it has one of the world’s flattest yield curves. What that means is that the difference in return you get from a 90 day bank bill is really not that much different from the return on a 10 year bond – currently less than half a per cent extra for locking your money away for 10 years.

This is one reason that Australians like plain old cash, because you can get a good return – far higher than in most other developed countries of the world – for pretty much no risk, though you do get taxed on the interest. “Cash performs quite an important role in the portfolio, but it depends on timing,” says Dorrian. “Over the last three years, the cash rate hovered between 3 and 4.75%, while the domestic bond index was offering almost 8%,” he says. At other times, it’s looked much more attractive.

One interesting shift is that there are more and more ways people can get exposure to fixed income. For example, increasingly one can buy listed bonds, including corporate bonds. “People can get yield through listed fixed income and can have that in their portfolio as a yield-producing asset in the same way that they would have shares in their portfolio,” says Craig Keary at Westpac, which has launched several listed bonds. “The beautiful thing about it is people can go online to their broker and put it in their portfolio.”

Growing concerns about inflation are making these securities more popular, Keary says. “We have an inflation-linked deposit, and we are seeing increasing interest in that from retail investors. People recognise that protecting their purchasing power is really important, and just having your money on deposit isn’t enough any more. You have to be looking at how does your fixed income investment keep pace with inflation, as well as delivering you a yield.”

The next development is likely to be exchange-traded funds that can invest in fixed income. At the moment, they are becalmed in a regulatory issue: ETFs have to be underpinned by listed assets, which bonds, in the main, are not. Negotiations are underway between product developers, ASIC and the ASX to find a way through. “When it will happen is unclear at this stage, but certainly we believe Australian investors will benefit enormously from a fixed income ETF market,” says Tom Keenan at iShares, the provider of the most ETFs in Australia. “It would provide easy access to capital protection.”