Bond market returns over time have less to do with capital gains or losses, they are largely driven by income.

Despite predictions that the end of the bond market is nigh, Lonsec’s income sector has expanded considerably over the past few years.

This growth has been driven by increased demand for financial products that pay regular distributions, the launch of the bond ETF market and an evolution of absolute return focused strategies that tend to have more flexibility to adjust duration and therefore sensitivity to rising bond yields and capital losses.

Lonsec Senior Investment Analyst, Libby Newman, said, “One of the most frequently asked financial adviser questions of the past few years has been ‘should I be getting out of fixed interest?’”

“As yields plummeted, driven by the extraordinary monetary policies adopted by global central banks, the number of articles calling the end of the bond market rose”.

Unlike equities, bonds provide some certainty in terms of their returns – a regular coupon and return of principal at maturity, assuming there is no default.  However, it is still possible for income funds to provide negative returns due to market value fluctuations.

For example, an investor may experience a loss if they are forced to sell when:

• Interest rates (and expectations of future interest rates) go up sharply – and the prices on bonds commensurately fall
• Credit spreads deteriorate (widen).

“However, it is important to remember that bond market returns over time have less to do with capital gains or losses, they are largely driven by income – regular interest payments and reinvestment income earned when cash flows are put back to work in the market,” said Newman.

“Indeed many periods of negative or soft returns are followed by strong years because the coupon interest and bond maturities can now be invested at higher rates.”

“The yield on an Australian Commonwealth Government 10 year bond has risen about 1.0% compared to this time last year, and the capital loss (if yields rise the price of the bond falls) pretty much cancels out the income earned over the year.”

However, there is much more to the debt securities market than Australian and US government 10 year bonds. Over the same period, credit spreads (the premium for investing in a company rather than with a government), have narrowed, so corporate bonds have been able to deliver a positive return, even with the headwind of rising yields.  Then there are floating rate bonds, which are also less impacted by rising yields than their fixed rate counterparts.

“So you can see that Funds that can tap in to the full spectrum can still deliver positive returns and an income stream,” said Newman.

So, should you get out of bonds?

“Well, you’d expect me to say no. Australians own fewer bonds than investors in other parts of the world and want steady income in retirement, so I am pleased to see Commonwealth Government Bonds increasingly visible and available for retail investors to trade. But you definitely need to understand what your bond fund can do before you invest in this type of financial product. ”

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The global fall in interest rates to very low levels following the 2008 financial crisis has provided fixed income investors with significantly above average returns, leading to suggestions of a bond bubble that could burst if yields start to rise rapidly.

The paper, authored by Rosemary Steinfort, Investment Analyst, Vanguard Australia, demonstrates that the characteristics of fixed income assets and the enduring role that they play in providing income, capital stability and diversification in a portfolio despite these concerns.

The paper describes why bond returns respond efficiently to changes in interest rates and have a well defined income stream.  In addition the transparency of central banks and inflation targeting policies reduces the likelihood of unexpected large interest rate adjustments.

Speaking about the paper, Greg Davis, Chief Investment Officer, Vanguard Asia-Pacific said:

“Bond markets operate differently to equity markets and this paper confirms that in reality a bond market bubble in the same context as we might define an equity market bubble is not possible.”

“By splitting the performance of a bond into income and price, we can distinguish that over the longer term, income will have the greatest impact on returns regardless of interest rate fluctuations.

“The key considerations for any prospective bond investor are related to their motivation for investing in bonds – if you are investing in bonds for their income or diversification properties, then you should not be concerned about changes in interest rates.

“However if you are investing in bonds because of past high performance, then you need to be realistic in your expectations, the next 10 years are unlikely to look like the past 10 years,” said Mr Davis.

The paper concludes that, in the main, investors should not view a bond bear market with the same level of apprehension as an equity bear market. Furthermore, a balanced diversified portfolio incorporating good quality defensive and growth assets should produce attractive risk return outcomes for investors over the long term, irrespective of interest rates.

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So when people say that a bond market bubble is inflating today – and quite a few are doing just that – my initial response is not to panic. Investment trends tend to last much longer than logic suggests they should. And as the famous economist John Maynard Keynes said, “The market can remain irrational longer than you can remain solvent”.

However, several stories in the past week or so have made me less confident.  First, I read that Britain’s pension funds now hold more of their assets in bonds than in shares. This has not been the case since the 1950s when the so-called “cult of the equity” began.

Investors have not been this gung-ho about fixed-income for 60 years.  Second, I saw that America had experienced its biggest ever week for inflows into bond funds, a total of US$9.4 billion. This was almost matched by the US$9.0 billion that flowed out of equity funds in the same week.

Finally, I noted that the yield on German government bonds had fallen to 1.3%, almost as low as it has ever been. At that level, investors are swapping a reduction in the real, inflation-adjusted value of their savings for the reassurance of knowing they will get their money back.

Something quite unusual is going on. Either the world has changed completely and investors will be content with derisory yields in perpetuity or they are setting themselves up for a disappointment. None of us who have lived through the lost decade for shares since 2000 want to repeat the trick with our bonds.

Figures from the Investment Management Association confirm that it is not just government bonds that are popular today. They show that in eleven out of the last 12 months more money has flowed into corporate bond funds than into any other sector.

The traditional homes for ordinary savers’ cash – UK and European shares – have been the least popular sectors over the same period.  In Australia, over the past three years, managed funds have seen some AU$14 billion in outflows from Australian equities, whereas Australian fixed interest has had net inflows of more than AU$2 billion over the same period.

It is not hard to see why investors are attracted to corporate bonds. In an environment of extremely low interest rates, it is almost impossible to achieve a decent income from a deposit account. To achieve an acceptable return on their money investors have to take some more risk. And bonds issued by the biggest and safest companies certainly look much better value than those issued by most governments.

The question for me is whether investors are right to have favoured bonds over equities. I think they have done so for a good reason – because they think bonds are intrinsically safer than shares – but  in doing so they may have under-played some important risks.  There are four principal dangers:

• The first is that the state of the economy could continue to deteriorate, pushing up the rate of company failures. If this happened investors might demand a higher yield to compensate them for the risk that they might not get their money back. For the yield on a bond to rise its price must fall. Existing holders would lose some of their capital in this case.
• The second risk is that the economy could pick up faster than expected. If this were to happen, central banks could raise base rates from their current 300-year low. Again, prices would fall.
• The third danger is that investors could all fall out of love with bonds at the same time. Fund managers might struggle to find sufficient buyers in such a situation, which could destabilise the market.
• Finally, there is the hidden risk of inflation, which many experts think might be the inevitable consequence of the quantitative easing or money printing of the past few years. Inflation is the enemy of bonds.

So what should investors do? First, I think they should look into whether their desire for income and security might not be just as well met by investing in high-dividend paying shares.

A balance of equity income and fixed income looks safer to me. Second, they should make sure that any bond funds they invest in have the flexibility to move between different parts of the fixed income universe. Not all bonds are created equal and a good manager will know where the value lies and, crucially, where it does not.

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