Planning ahead for the day that you leave your business is a vital business planning strategy. No matter what your business is currently worth, owners who plan now for the succession of their business can put themselves a step ahead in ensuring the future success and value of the business.

Astute business owners realise that taking the time to put a succession plan in place for their business gives them a clearer picture of the future. They recognise that it prepares the business for acquisition or extending ownership and ensures that the business will continue to serve its clients when the business owner retires or wishes sell down part of her business equity in transitioning to full retirement.

After identifying the appropriate successor(s) for the business one of the fundamental issues for business owners is to seek advice on how to identify and establish an appropriate funding mechanism that is both tax effective and supports any buy/sell or key man arrangements that have been put in place with the proposed successors.

A strategy to consider for the business owner is a funding mechanism based on investment bonds which offer several benefits including taxation and protection from creditors in the event of bankruptcy.

Investment Bonds

A ten year investment bond offers key advantages when used as part of a strategy to fund a business succession arrangement. An investment bond is a tax paid structure that, under current taxation law, pays tax on earnings throughout the life of the bond to a maximum of 30%. The proceeds of an investment bond are received without any additional taxation after year 10; are protected from creditors while held as investment bond and do not form a part of the estate of the bond owner in the event of death. On the latter point, the proceeds are paid directly to the bond owner or, in the event of death, the bond owner’s estate or nominated beneficiary.

As such, investment bonds can be used successfully to provide the business owner with some certainty of transition of their business interests at an agreed price over a ten year time-frame.

Tax Issues

If the investment bond is withdrawn within the first eight years all of the growth is assessable in the bond owner’s income tax return. If withdrawn during year nine, two thirds of the growth is included as assessable income and if withdrawn in year ten, one third of the growth will be assessable. Beyond the ten year period none of the growth is assessable to the bond owner.

Ownership Structure

There are two parties to an investment bond and they are the bond owner and the life insured. In the case of funding business succession, the bond owner will be the business successor – the person who will by buying all/part of the business. The second party – the life insured – will be the current business owner. In the event of the death of the business owner before completion of the ten year period, proceeds from the investment will be paid to the bond owner. Note that as per the above, taxation will be a consideration in such an event for the bond owner (business successor) if a death payment is made prior to the end of year ten.

Will the investment bond savings plan be sufficient?

Very likely, in the early years of saving via an investment bond, the accrued savings will not be sufficient to purchase a business, or part of it, in the event that the business owner dies. There could be a substantial shortfall which dictates that the business successor should implement a stand-alone life insurance policy(s) on the of the business owner which will facilitate purchase of the business from a deceased business owner’s estate if the owner were to die.

Note here that the receipt of life insurance policy proceeds might l have tax implications and each situation will require tailored legal advice before the stand-alone insurance policy on the business owner’s life is established.

ncome in the bond owner’s tax return and during year ten, one third of the growth is included

Advantages of utilising a bond structure to fund succession

There are a two key advantages to using an investment bond to fund a business succession arrangement:

1. There is no additional tax payable on withdrawals after 10 years.

Where a buy/sell agreement is established between a business owner and an employee to transfer all or part of a business at a future date for an agreed value, the agreement can reference the establishment of an investment bond to be funded through regular savings by the employee/successor which can, for example, be derived from all or part of the employee’s/successor’s future remuneration increases. Such savings could also, for example, be derived from part/all of the employee’s/successor’s future bonus payments.

2. Importantly, the proceeds of the investment are protected from creditors in the event of bankruptcy.

Case study– Business succession planning

John and Jane

John wants to sell half of his business to Jane over the next ten years – the future value of the business is valued at almost $1 million and Jane agrees to lock in the sale price to purchase 50% of the business in ten years’ time.

With the appropriate buy/sell agreements in place, Jane invests $35,000 into an investment bond. Subsequently, Jane then invests a combination of her savings and bonuses – of $35,000 per year – over the next nine years. After the tenth anniversary of her bond and using a hypothetical after tax and fees earnings rate of 5% per annum, Jane will have $460,000* to fund the purchase of 50% of John’s business.

*Illustrative example only. 5% post tax and fees return equating to a 6.5%pre-tax return and assumes 1% p.a. fees). Each bond will have different investment strategies and risk profiles and may experience both positive and negative returns, and this would materially impact the outcome.  The examples given may not reflect the real outcome achievable and is not a forecast or opinion in respect of any of returns achievable within any investment bond.

Other benefits of utilising an investment bond for business succession

The main benefit of an investment bond is its potentially advantageous taxation features, however, it also offers other benefits that make it a good option in funding a business succession.

Flexible investment options

Investment bonds allow investors to access many asset classes and provide a market-linked investment vehicle to help meet investment goals.

No limit on the investment amount

There is no limit on the amount that can be invested to establish an investment bond. Investors can also make subsequent investments up to maximum of 125% of the previous year’s contribution without restarting the ten year period. Investors can choose to start new investment bonds if higher amounts are to be invested.

Flexibility

While there is a ten year period in regards to taxation, investment bonds give investors the flexibility to access funds at any time.

Capital gains tax simplicity

Investment bonds provide simplicity as earnings are automatically reinvested in the bond. This means reinvestment dates do not need to be tracked for capital gains tax purposes. Investors can also switch between investment options without triggering personal capital gains tax.

Transfer of ownership

The ownership of the investment bond can be easily assigned or transferred at any time. The original start date is retained for tax purposes. This may not be achieved within a company structure without creating tax liabilities.

Bankruptcy protection

Investment bonds may offer protection from creditors in the case of bankruptcy (subject to certain rules), which may not be provided through a company structure.

Conclusion

If you are an advisor looking for a tax effective investment to help your clients fund their business succession plans, then investment bonds offer one potential solution which is accompanied by a range of investment options. When anchored to a well-constructed Buy/Sell Agreement, investing in an Investment Bond enables a business owner to establish an agreed business exit strategy while enabling the successor to accumulate the assets needed for the purchase of their share.

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Disclaimer: This whitepaper is issued for the use of financial advisors only. Suitability of an investment in a Centuria Investment Bond will depend on a person’s circumstances, financial objectives and needs, none of which have been taken into consideration in preparing this whitepaper. Prospective investors should obtain and read a copy of the Product Disclosure Statement (PDS) for any investment bond and consider the information in the PDS in light of their circumstances, objectives and needs before making a decision to invest. This document is not an offer to invest in any of Centuria’s Investment Bonds. Issued by Centuria Life Limited ABN 79 087 649 054 AFSL 230867.

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Investors looking at their medium-term and long-term investments are currently asking themselves: what is in store for bonds when rates normalise? As central banks’ bold experiment in monetary policy comes to an end and they begin to normalise cash rates, many investors fear possible negative returns on bonds, such as we had in 1994, which is notorious as the year of the great bond rout. Either we will see an orderly bond selloff (with a slow, steady rise in yields) as the central banks successfully manage to exit quantitative easing (QE) without causing market panic, or we may experience a disorderly one if central banks lose control of the process. Another possibility is that there is a selloff caused by inflationary fears. Whichever scenario one subscribes to, the outlook for bonds does look risky.

Obviously with any asset class, investors must ask the question: does the cost of holding bonds outweigh the benefits of holding bonds? In our view, the answer is no. Bonds remain an important component of a portfolio: even in a rising cash rate environment, diversifying a portfolio so that it includes fixed income alongside other assets can help balance returns, diversify risk and reduce overall volatility. The approach should not be to avoid or sell out of bonds, but to look at the types of bonds in a portfolio and to adopt a flexible, active approach that helps cushion the bond portfolio against rising rates.

Bonds are the only truly defensive asset

Over the past few decades, Australian investors have largely ignored fixed income investments, preferring cash or term deposits as the defensive assets in their portfolios. Although they believed they were investing in asset classes which were getting higher returns, actual returns were higher for true fixed income funds since cash and term deposit holdings missed out on the capital returns enjoyed by bonds.

In addition, these investors missed out on the major benefit of holding high quality bonds – the negative correlation they provide to equities. Although bonds don’t generally deliver the high returns that equities do, holding them in addition

to equities should decrease the risk in a portfolio. In market environments when equities are performing poorly, the bond holding can help to offset losses on the equity portion. So it’s possible to construct an efficient portfolio that maximises potential returns while helping to minimise risk. This cannot be done with other defensive asset classes, such as cash or term deposits, because their correlation to equities is zero and can even verge on positive in the long term since falls in equity markets can lead to cash rate cuts by central banks.

Bonds tend to perform relatively better in market downturns and when, due to very low inflation or deflation, prices are falling. Although bonds may perform well during times of low inflation or deflation, such an environment is bad for most other asset classes, particularly equities. Central banks around the world have strived for low inflation, but the risk from any cyclical fall in inflation can lead to a deflationary scare in financial markets, such as we saw in 2001 and 2009.

The reason why we have seen such a bold QE experiment by central banks is that they have learnt how to deal with inflation and have the tools to do so. However, most have not had to deal with deflation and don’t necessarily have the tools to handle such a scenario. Japan in the 1990s and the US in the 1930s are examples of the risk of deflation and the difficulty it takes to get out of such a situation once in it. With low world inflation and the weakening of conventional monetary and fiscal policies, deflation is still a potential risk for investors to consider, just as inflation was in the 1970s and 1980s. Maintaining an allocation to bonds would help to offset this risk given their superior performance in such an environment. Cash and term deposits would not offset the risk of deflation because the RBA would cut the cash rate to very low levels in order to try to jump-start the economy in that scenario.

Assessing risk for bond portfolios

The short-term risk of higher rates is compounded by the current relatively low yields and the fact that duration has increased for bonds and the typical benchmarks. The lower a bond’s duration, the lower its price volatility and the less sensitive it will be to interest rate changes. The duration of the UBS Composite Bond Index 0+YR (the benchmark for most Australian bond funds) is currently around four years compared with three years prior to the GFC1. The major reason for this is that government issuance since the GFC has tended to be longer in nature. For example, Australia issued a 20-year government bond in November, the longest maturity bond to be issued since the 1960s.

Apart from duration, it’s important to consider what will happen to bond yields when assessing what a rise in rates will do to bonds. The most important consideration is when and how orderly, or disorderly, the bond selloff is. If rates were to rise and bond yields rose in an orderly and steady manner, they wouldn’t suffer large losses. However, in a disorderly selloff or market panic, it’s possible that we could see negative returns, as in 1994. The big risk to bonds isn’t so much rising rates, it’s rapidly rising rates. A fact that might surprise some investors is that in the past 20 years, Australian bonds have only experienced negative returns twice, in 1994 and 1999. Although 1994 saw a very disorderly selloff in the bond market, it only delivered a negative return of  4.66%, with -1.22% for 1999 . The most common returns over the whole 20-year period have been between +5% and +15%.

In addition, unlike capital losses experienced on equities, capital losses on bonds are recovered over subsequent periods until maturity. This is called the ‘pull-to-par’ effect: As a bond approaches maturity, its market value gets closer and closer to its face value based on an assumption by the market that the bond will be repaid in full and on time. Even if rates do rise and prices fall, as long as the issuer remains solvent, investors will receive repayment of their full capital investment at the bond’s maturity. So, if you hold a bond until it matures, you won’t lose your principal. The potential for capital loss thus only comes when selling a bond before it matures or if the issuer defaults.

New natural rate of interest is around 4%

Quantitative easing from global central banks has depressed real rates and term premiums. The chart below shows how we believe the new natural interest rate (NRI) has changed from being around 5-5.5% from the start of the century until the GFC, to around 4-4.5% since then. In our view, the reasons for the drop are pressure on the government to rein in spending and that since the Reserve Bank of Australia (RBA) started cutting the official cash rate, Australia’s banks have retained around 100 bps of those cuts and not passed them on.

Source: Bloomberg

If rates were to normalise, we should expect the cash rate to head toward this new NRI, so potentially the extent of the rise over time would be around 150-200 basis points (bps). Obviously, the NRI can change temporarily, but this means the extent of the selloff shouldn’t equate to 1994.

In our view, the concept of duration should be rethought, particularly as it applies to individual bonds. As a measurement of risk in a portfolio, duration is still highly relevant since it measures the portfolio’s sensitivity to interest rates. However, that does not mean that long duration bonds are necessarily more risky – as the chart above shows, 10-year bonds are currently within the 4-4.5% band of this new NRI. If long-term rates don’t move or don’t move by too much, then longer duration bonds shouldn’t be particularly affected. If we saw the cash rate rise to 4.0%, then it would be the yield on the shorter maturity bonds which would react the most and despite their shorter durations, they would suffer worse losses than higher duration bonds. Longer duration bonds are more vulnerable to central banks decreasing their purchases or decreased foreign investment in Australian bonds as the supply increases. However, a normalisation of cash rates would not hurt all maturities of bonds equally.

Because a bond portfolio comprises a variety of bonds with different interest rate levels and maturities, it should have a steady stream of maturities which can be invested at the higher yields if cash rates/yields are rising. By owning bonds of different maturities, fund managers ensure that they are not tying up money for too long. If and when interest rates go up, maturing assets offer the opportunity to reinvest that capital into more recently issued, higher yielding bonds. As such, the effect of any return erosion is constantly being reduced and so any capital losses on bonds should be recovered over time. It’s important to remember that not all bonds are the same: a diverse portfolio containing different bond types and maturities helps to minimise any potential losses.

Conclusion: Bonds remain a good long-term investment

Bonds remain a viable asset class despite the risk of higher rates in the short term. Apart from bonds’ defensive qualities and negative correlation to equities, the longer term threat of deflation and the impotence of central banks to deal with it also warrants an allocation to bonds. The question is which bonds to invest in and at what level. Good value can still be found in various areas of the bond market, such as semi-government, bank and some corporate bonds, as well as by using duration and yield curve strategies. Opportunities remain to add value through bonds via active management using a variety of different strategies in combination to produce a diversified, well performing portfolio.

By Roger Bridges

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“Tyndall AM”). Tyndall AM is part of the Nikko AM group. The information contained in this document is of a general nature only and does not constitute personal advice. Nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The information in this document has been prepared from what is considered to be reliable information but the accuracy and integrity of the information is not guaranteed by the Company. Figures, charts and other data, including statistics, in these materials are current as of the date of publication unless stated otherwise. In addition, opinions expressed in these materials are as of the date of publication unless stated otherwise. The graphs, figures, etc., contained in these materials contain either past or backdated data, and make no promise of future investment returns etc. Past performance is not a reliable indicator of future performance.

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The future of fixed income.

Roger Bridges, Head of Fixed Income and Anita Daum, Head of Portfolio Management and the portfolio manager for the Tyndall Australian Bond Fund have provided their answers to AdviserVoice on fixed income and the future for bonds.

Roger has 30 years’ experience in the fixed income market, and has overall responsibility for managing and implementing the strategy for Tyndall’s fixed income portfolios. Anita has 11 years’ experience in the fixed income market and has been managing the Tyndall Australian Bond Fund for four years.

Why did bonds take such a hammering in June?

Roger:  The June reaction of bonds was due to the market’s expectation for the reversal of quantitative easing or QE in the US. Bonds prices surged to record highs in recent years, in part due to central banks such as the US Federal Reserve and Bank of England buying them under QE programmes. The intention – and the effect – was to push down bond yields, which move in the opposite direction to prices.

Low bond yields tend to cause interest rates to fall. This helps to reduce the cost of borrowing for consumers and governments and boost the prices of other assets such as shares. These effects can help pull a country out of recession and assist economic recovery.

But as the recovery gathers momentum, central banks try to curtail and then reverse QE, sending the previous trends into reverse. Announcements by the Fed in June that it planned to scale back its QE programme sparked fear among investors, sending bond prices in the US sharply lower and yields higher. Our bond market is strongly affected by the movement of US bonds, particularly longer-dated bonds such as the 10-years. As a result, we also saw a sell-off here with yields rising and bond prices falling below fair value.

Following this upset, the Fed was forced into a partial retreat and tried to calm market fears over QE tapering, which caused bond yields to fall back to more normal levels. In fact, July saw Australian bond market indices post modest positive returns as bond yields fell.

Can we expect more volatility in the short term?

Roger:  In our view, September seems to be a likely start date for the US Fed’s tapering of its bond-buying programme. The Fed indicated back in June that it may start tapering next month and recent strong economic data makes this all the more likely. In the past week or two, we’ve seen strong US employment and consumer price data.

Given the strong correlation between the movement of US government bonds and Australian government bonds, bond market volatility remains a strong possibility as the market tries to work out what the effects of tapering QE will be.

As growth improves in the US and this tapering of QE comes into effect, how likely is it that we will see another 1994 with bonds experiencing negative returns?

Roger:  It is possible, though unusual, for bonds to deliver negative returns. In general, this only occurs when either the cash rate unexpectedly increases by a large amount or the bond market tries to price in unexpectedly large rate increases and adjusts these expectations quickly. If these market expectations are slowly priced in, then the market value of bonds may fall but they don’t experience negative returns, only lower returns.

This is what happened in 1994: The Fed and its chairman Alan Greenspan were worried about inflation following the 70s and 80s and so decided to take swift action to avoid a spike in inflation. The market was surprised by the sharp rate hikes that the Fed introduced and US bonds didn’t respond until the rate hikes occurred since they were not well telegraphed in advance. The market then panicked and bond yields jumped, while prices fell. 2004-2006 also saw rate hikes in the US but because the Fed was more transparent and took action more slowly, the market had time to react to avoid bond losses.

The current situation is likely to be a repeat of 2004-2006. The Fed is telegraphing its moves in advance so the market shouldn’t be taken by surprise, although there might be brief periods of panic, like in June. But in the longer term, QE unwinding and rate hikes will be slow, measured and telegraphed in advance which shouldn’t lead to bond losses even though the trend will be for yields to rise.

Focusing back on the domestic economy, what’s the likely impact on our bond market of the upcoming Federal election?

Roger:  There is unlikely to be much of a reaction. In general, investor confidence should improve if there is a clear-cut outcome, with one party obtaining a decent majority. A hung parliament will be a negative for confidence and add to uncertainty.

Whichever party wins, if they intend to achieve a fiscal surplus, then obviously that will have an effect on bonds due to the reduction in bond issuance. If there are fewer bonds on issue, it should help to support pricing and keep yields lower.

With prices surging to record highs in recent years, is it fair to say that Australian bonds have had their day?

Roger:  Given historically high prices and low yields, investors have been questioning whether bonds have had their day. I don’t think this is the case.

Australian 10-year bonds have fallen from around 15% in 1982 to record lows below 3%.  The decline in bond yields has been largely the result of a structural decline in global inflation expectations, partly due to QE from central banks around the world and partly to slowing population growth and an aging population.

But in the shorter term, there are three main reasons why Australian bonds should remain attractive.

1)     Foreign investment. Even though this has started to drop off, it is still historically very high. Before the GFC approximately 20-30% of our bonds were held offshore, but by this year, it had jumped to just under 80%. This is largely due to other central banks wanting to diversify away from currencies such as the US dollar.

2)     QE globally. For Australia, this artificial suppression by other central banks means that there is increased demand for our higher yielding assets. Although interest rates are at record lows, our cash rate of 2.5% is still much higher than the zero or close to zero rates seen in Europe, the UK and the US.

3)     Our AAA rating. Australia is one of only 8 countries that has a AAA rating with a stable outlook from all 3 major rating agencies (Standard & Poor’s, Fitch, Moody’s).

So, in a world with a still highly volatile macroeconomic backdrop, the combination of very loose monetary policy in other countries and foreign demand for our debt due to its yield advantage should help to support the bond market in the medium term. We don’t envisage many catalysts that would suddenly push bond yields upwards for a sustained period.

Anita, why should an investor maintain a bond allocation in their portfolio?

Anita: Australians have traditionally invested in shares rather than bonds. But bonds are a valuable component in a diversified portfolio. Bonds tend to perform relatively better in market downturns and when deflation is a major risk. Diversifying a portfolio so that it includes fixed income alongside other assets can help balance returns and reduce overall risk.

Although equities can offer the potential for greater returns more quickly, they involve considerable volatility and the potential for capital losses. Fixed income, on the other hand, offers regular, predictable income with a greater likelihood of capital protection and much more stable returns over the long term. It’s the non-correlation to equities that’s important – bonds should outperform when equities are underperforming and vice versa. So it’s important to have some of a portfolio invested in bonds.

What do you think an investor should look for when choosing a bond fund to invest in?

Anita:  If an investor wants a core bond holding to diversify their portfolio, then they should look for a traditional “true-to-label” bond fund to offset the volatility of other market sectors and provide that non-correlation to equities risk.

A fixed income fund should perform well in market downturns, providing the consistency of performance and regular income that investors expect. However, it’s important to note that not all bond funds are the same. For example, some funds are able to allocate large portions of their portfolio to credit. This gave investors in some of those funds a nasty shock during the GFC. Instead of the fixed income portion of their portfolio doing its job and being the outperformer during that time, funds that were very overweight credit actually performed badly and in some cases actually delivered negative returns during that period.

Our flagship bond fund did very well during the GFC because it is a true-to-label fund that is highly risk-aware and designed to deliver consistent performance even through serious market dislocations, when equities are doing badly.

So, it’s important to consider what an investor wants from fixed income and choose a fund accordingly. If it’s a non-core holding and the investor is looking for a higher return and is prepared to take on extra risk, then a fund that is able to invest in riskier securities could be appropriate. But if the investor is looking for a core holding, then they want a conservative true-to-label fund that won’t give them any nasty surprises at a time they can least afford them.

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Disclaimer

This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“TIML”). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The Tyndall Australian Bond Fund ARSN 098 736 255 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (“TAML”).  Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest.  TIML and TAML are wholly-owned subsidiaries of Nikko Asset Management Co., Ltd.

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Growth in US equities predicted.

Despite the strong upward trend in global equity markets, equities should be favoured over bonds and cash, although equities are expected to outperform bonds by a smaller margin than in the first half of 2013, according to Russell Investments.

This sentiment is contained in Russell Investments’ 3rd Quarter Strategists’ Outlook and Barometer, a quarterly assessment of global capital markets. It features in-depth analysis of key economic and market indicators by Russell’s global team of investment strategists, who help guide Russell’s multi-asset portfolios and services.

In the report, steady growth is projected for the U.S. market over the next 24 months, forecasting the U.S. economy has sufficient spare capacity to grow without generating inflation pressures. Within global equities, Russell strategists prefer Europe and Japan due to slight improvements in the Eurozone, the success of ‘Abe-nomics’ in Japan, and the overall attractiveness of Japanese and European equity valuations relative to U.S. valuations.

Russell Investments senior investment strategist, Asia-Pacific, Mr Graham Harman, said Asia-Pacific offers opportunities in Japan, China and Australia.

“Japan is experiencing strong GDP growth for 2013, and the Chinese government is prioritising reform over short-term growth,” Mr Harman said.

Locally, while there are encouraging signs in Australia’s housing sector, the economy faces a slowdown.

“The overwhelming challenge domestically is to absorb the impact of a precipitous decline in resource sector-related capital spending, and to take up the slack in export growth, in housing, and in domestically oriented industries,” he said.

Russell Investments global head of investment strategy, Mr Andrew Pease, said economic growth in the months ahead will remain modest but robust, with Europe emerging from recession and Japan set to accelerate.

“The gains in global equity markets and rises in bond yields mean that we head into the second half of the year with equity markets offering reasonable, but not outstanding value, and with bond markets less dangerously overvalued,” he said.

Emerging markets may underperform in the near-term, but prospects are improving 

Conditions in emerging markets remain challenging for equities, given the strengthening of the U.S. dollar (USD), falling commodity prices and general geopolitical upheaval in countries from Brazil to Egypt. However, Russell’s strategists believe an export recovery and a settling of the current uncertainty around China could serve as catalysts for a rebound in the medium-term.

“Emerging markets offer good value and could rebound as exports recover amid stronger growth in developed economies and if EM central banks allow their currencies to depreciate against a stronger USD,” Mr Pease said.

Despite some challenges, U.S. economy likely to generate stable growth 

Russell’s strategists believe that U.S. employment gains will likely average 200,000 jobs per month for the next 24 months. The first increase in the federal funds rate likely won’t take place until the fourth quarter of 2015. However, the June revision to the annualised real consumption figure, which lowered the growth rate from 2.9% to 1.8%, implies less momentum going into the second half of the year.

Another challenge will be the U.S. Federal Reserve’s (the Fed) wind down of quantitative easing that is likely to begin in 2013, though it is the end date that is most significant. Russell believes the Fed is unlikely to hit their growth, inflation and Treasury yield targets this year.

Many investors fear that the current economy resembles 1994 where the Fed policy tightened dramatically, leading to a sudden rise in yield rates and choking equity growth. Russell Investments’ perspective is that the economic conditions today parallel 1984 more closely, when a bullish U.S. economy forged the way for stable global growth. Russell expects the U.S. economy to be characterised by moderate inflation, a low recession risk and stable growth.

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The great rotation from bonds to equities

While recent extreme volatility in global bond markets again raises the question of the role of fixed income in investor portfolios, new analysis from AXA Investment Managers (AXA IM) shows the significant impact a “great rotation” from bonds to equities could have on investor portfolios.

In The Great Rotation paper AXA IM’s leading researchers discuss and analyse investors’ capacity to take on additional risk and the potential for significant asset allocation shifts in the current market environment.

A great rotation is a big shift of strategic long term asset allocation driven by a combination of factors, including: long-term risk budgeting, the regulatory environment, monetary policy and liquidity. In 2013, AXA IM analysis shows these factors have seen a shift from cash to equities, rather than bonds to equities as investors risk appetite returns and they seek higher returning investments.

However, AXA IM’s Director of Australia & New Zealand, Craig Hurt, said any ‘great rotation’ of investor portfolios from bonds to equities could have multiple repercussions on investment decision making.

“For such a move to occur, both market and regulatory conditions would have to support greater appetite for risk. We evaluated the concept of a great rotation with regards to investors’ long-term investment objectives. The impact of a great rotation in global markets on the average Australian could be significant if their asset allocation is not given due attention,” he said.

“Similarly, if there is indeed a great rotation out of bonds and into equities at the same time Australian retirees are moving out of equities and into bonds in the search for a reliable income stream, then retirees may find themselves on the wrong end of a big global trade,” Mr Hurt added.

Focus on the fixed income landscape

According to AXA IM, while bond investors may already have come to terms with the risk that their exposure to high rated government and investment grade bonds will deliver negative real returns over the medium term, there are still a number of options for fixed income investors in an environment of asset class rotation including; reducing portfolio duration, adding inflation protection and yield pick-up.

“Investors can minimise interest rate risk by limiting the duration of their portfolios or by further replacing interest rate risk for credit risk. There is also a strong argument for seeking inflation protection,” Mr Hurt said.

AXA IM believes there are a number of important questions investors should ask to understand the risk of significant asset allocation shifts from bonds to equities.

Firstly, will other assets offer greater certainty of higher returns if bond yields are to remain very low? Secondly, are we on the verge of a bond bear market that will generate a period of negative returns in fixed income? Third, if that is the case, will it be through higher interest rates or a re-pricing of credit risk premiums? Lastly what can bond investors do in an environment of asset class rotation?

Such questions are even more important for an ageing Australian population as they move from the accumulation to decumulation phase.

“Whereas in the accumulation phase there is a focus on real-return growth assets, the investment strategy in the post-retirement world is generally centred on capital protection, inflation protection and yield generation,” Mr Hurt concluded. .

AXA IM’s Great Rotation paper provides an in depth analysis of options available to investors across the various asset classes.

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• Sovereign bonds have had a great run, but with yields near record lows and global growth improving this is unlikely to continue.
• A 1994 style bond crash is a risk, but unlikely at this stage as it’s hard to see monetary tightening this year. The most likely scenario is a gradual grind higher in bond yields. This could still see bonds return zero this year.
• Very low bond yields highlight the need for active fixed income management where the portfolio manager can increase the exposure to less vulnerable credit and reduce a portfolio’s duration to limit the impact of a rise in bond yields.

 To read this report, please click here.

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However Australia Ratings considers that the changes in and of themselves are unlikely to be “game changers”. Nonetheless, the Government initiative is encouraging in signalling to the market the importance of having a larger and more active bond market in Australia.

Such an outcome will benefit companies who may wish to diversify their sources of debt finance and provide a larger pool of “plain vanilla or simple corporate bonds” for Australians to invest in as part of the capital stable component of their investment or retirement income portfolios.

Assuming the stipulation that to qualify for the revised treatment under the Corporations Act bonds need to be secured is a drafting error (we believe this was intended to be that bonds are not to be subordinated to other unsecured creditors), the most interesting item of the Government announcement is the new depository interest mechanism which will potentially allow trading by retail investors through the ASX of bonds held in the Austraclear clearing and settlement platform. The first bonds to trade through this mechanism will be bonds issued the Australian Government.

The use of a depository interest mechanism for bonds lodged in the Austraclear system and deemed to be simple corporate bonds will in the medium term unlock a larger pool of bonds in which retail investors will be able to invest.

The ‘game-changer” for the bond market will be when retail investors have access to a more diversified supply of investment options and a pool in which there is both retail and institutional investor trading.

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The growing importance of income investing was revealed by recent research carried out among Fidelity Worldwide Investment’s institutional investors. The independent survey of major institutional investors across Europe and Asia was undertaken by Greenwich Associates and revealed that most investors have experienced a fall in returns in recent years, which has led to an increased emphasis on income and a greater willingness to consider a wider range of income-paying assets.

“Low interest rates and bond yields are encouraging a search for yield that forces investors – institutional, wholesale and retail – to look towards assets with more attractive risk-reward characteristics,” said the Fidelity The Age of Income study.

It found “the search for income – already a powerful investment theme – is set to grow in importance over the next decade and beyond.”

The study revealed several asset classes that were being favoured by institutional investors over the next five years:

• investment-grade bonds (both developed and emerging markets) and high-yield bonds
• equity dividend income
• real estate strategies.

“Within traditional asset classes, there has been a shift towards investment-grade credit (developed and emerging markets), high-yield bonds and high-dividend equities. Together with real estate investment and infrastructure these are the asset classes considered to provide the most favourable trade-off between income and the risk to the underlying principal.”

Fixed income: looking beyond government bonds
There has been a 70% reduction in the pool of sovereign bonds with AAA status over the past year, the study found. It also noted the demand for assets considered safe had been significant and put downward pressure on the yields of US and German bonds – and increasing the price of safety.

The study urged investors to differentiate between government bonds and invest in fiscally sound sovereigns, such as Canada and Australia, and include the highest-quality investment grade corporate bonds of robust multi-nationals – as such companies offer better credit risk characteristics than many sovereigns and allow investors to offset sovereign concentration risk.

Equity dividend income: historically attractive yields
In the long run, if dividends are reinvested to augment the capital accumulation rate, equity income is a compelling strategy for investors who do not require cash distributions.

The study noted the extra returns from dividends can also provide a valuable margin of safety against price declines if volatility continues.

However, a high yield alone does not necessarily imply value. This was readily demonstrated in 2008 when bank earnings dropped sharply, by such a degree that dividend payments were no longer sustainable for many US and European banks. A fundamental approach focused on companies with robust financials and business franchises that allow them to sustain, or grow, their dividends is key.

Commercial real estate: driven by income returns
Commercial real estate returns are dominated by income, with around two-thirds of total return from real estate attributable to income.

The current point in the cycle provides an opportunity to access historically high yields and the prospects for long-term capital appreciation are good, noted the study.

Overall, the study said “what might have been seen previously as a move up the traditional risk spectrum can be characterised as a measured response to a changing risk landscape and a willingness to consider higher yielding assets that look more attractively valued.

“We believe the current market environment offers an opportunity to access attractive yields without necessarily taking on significantly more risk in fixed income portfolios, quality-focused equity-dividend portfolios and commercial real estate portfolios.“ In terms of risk, the study found “unsurprisingly, credit/sovereign risk in the search for higher investment income was cited most often as the key risk to the principal value of investments. Interest rate risk was next.”

The study summarised the shift in investment strategy as:

This shift in allocation is likely to alter the investment landscape as income producing investments are bid up by investors.

“At a time when traditional sources of supply are shrinking, demographic factors are increasing the demand for income. A surge in the number of retirees and increased longevity means more people in retirement for longer, needing more income to maintain their living standards.

“The global retirement population is set to surge from 800 million in 2011 to 2 billion by 2050, (according to the United Nations). Average life expectancies have increased markedly in the last 50 years. Individuals being born in developed nations now can expect to live well into their 80s on average. This is forcing a major reassessment of how much money/income pensioners need in retirement.”

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. Prior to making an investment decision, retail investors should seek advice from their financial advisers. Investors should also obtain and consider the Product Disclosure Statements (“PDS”) for any Fidelity fund mentioned in this document. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise.  © 2012FIL Responsible Entity (Australia) Limited.  Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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Over the last year global bonds returned 11.1% and Australian bonds returned 11.4%. Over the last two years they have returned 10% per annum and 8.7% pa respectively. With such strong returns it is worth asking whether they are in a bubble. Our answer is no, but they could certainly be considered poor value and there are much better return opportunities elsewhere.

Generational lows
Despite seeing their sovereign rating downgraded from AAA last year, US 10 year bond yields have fallen to their lowest level on record (based on data dating back to the 1850s). 
 

Australian bond yields are at their lowest level since 1951. 

 
Bond yields in the UK, Japan and Germany are also running around generational lows, if not record lows.

What has driven bond yields so low?
The sharp decline in bond yields from the early 1980s can be largely explained by the shift from a high inflation to a low inflation world. The more recent fall to extreme lows reflects a combination of factors, flowing from the Global Financial Crisis and its aftermath.

• First, sub-par economic growth and benign inflation have further lowered equilibrium levels for bond yields.
• Second, and related to this, market expectations for short term interest rates have been continuously revised down over the last few years. Several central banks have been cutting interest rates again since late last year (eg, the ECB, the RBA and central banks in emerging countries) while the US Federal Reserve, the Bank of England and the Bank of Japan have left interest rates near zero. Furthermore the Fed has indicated that rates are likely to stay near zero at least out to late 2014, after previously indicating out to mid 2013. The historical experience tells us that the longer short term rates stay low, the more likely it is that long term bond yields will converge on them as expectations of future short term rates are revised down. This is exactly what has happened in Japan over the last two decades, particularly during the 1996-98 period. The US, UK and Germany appear to be going through something similar

• Third, the US Federal Reserve and the Bank of England have been actively buying government bonds as part of their quantitative easing programs, which are designed to keep private sector borrowing rates as low as possible and encourage banks to lend. This, and the expectation of more to come following recent comments from the US Federal Reserve, has had the effect of keeping bond yields lower than might otherwise have been the case.
• Fourth, the US Federal Reserve introduced “Operation Twist” which involved selling short term bonds and buying long term bonds in September last year in order to further keep down long term bond yields and hence private sector borrowing costs.
• Finally, safe haven demand for bonds from investors has been boosted in response to the worries last year about another global economic downturn, partly resulting from the intensification of the debt crisis in peripheral European countries. In this regard it’s worth noting that sovereign bonds in perceived core countries have been the best safe haven through recent bouts of share market turmoil. As such they have been in strong demand as a diversifier.

What about Australian bond yields?
Australian long term bond yields are a function of the level of bond yields globally and particularly in the US, expectations regarding short term interest rates as set by the RBA and perceptions regarding the riskiness of Australian government bonds. All of these have been pointing lower recently.

• Global and US bond yields have been falling for the reasons noted above.
• The Reserve Bank started to cut interest rates late last year and is expected to cut further.
• Australia is one of a diminishing group of 11 countries to still have a safe AAA sovereign credit rating. This has resulted in safe haven demand for Australian bonds, subsequently benefiting the Australian dollar.

Not a bubble, but not good value
Given the sound fundamental reasons for bond yields being so low it’s hard to agree they are in a bubble. Similarly, it’s unlikely we will see a big change in many of the fundamental factors that have pushed bond yields down any time soon. The global economic recovery is likely to remain anaemic and fragile for a while yet, global inflation is likely to fall further on the back of high levels of spare capacity, short term interest rates are expected to either remain low or fall further depending on the country, and further quantitative easing is likely in the US, UK and probably Europe. In Australia, the RBA has further easing ahead of it and safe haven demand for Australian bonds may have further to go as more countries are at risk of losing their AAA rating. Given this, it’s hard to get particularly bearish on bonds.

Against this though, bond yields at generational or record lows are poor value. (In the same way shares would be, for example, if dividend yields and earnings yields were at record lows.) Over the long term there is a rough relationship between bond yields and long term nominal economic growth (inflation plus real economic growth). The following table looks at current ten year bond yields relative to our assessment of their long term value based on each countries’ potential long term nominal GDP growth. On this basis, bond yields are well below long term sustainable levels.

Furthermore when bond yields are low, strong returns can only be had if yields fall further. This is what happened last year in Australia, for example, where the 10 year bond yield fell from 5.6% at the start of the year to 3.7% at the end, resulting in roughly 8% of capital growth for investors who held such bonds. Now with Australian bond yields much lower and sub 2% elsewhere, it’s now very hard to see this being repeated, unless there is a complete meltdown in Europe resulting in a return to global recession.

If bond yields track sideways, returns will be no more than current yields, eg, 1.8% in the case of US 10 year bonds and 3.7% in the case of Australian 10 year bonds. Alternatively, if bond yields back up by say just 1%, which will still leave them well below long term fair value measures, investors will suffer roughly a 4% capital loss taking returns negative.

What does this all mean for investors?
Global central banks want to keep bond yields low until a sustainable recovery is clearly underway. This might take some time so it would be premature to bet on a bear market in bonds. Similarly, sovereign bonds are a good diversifier in times of worries about the growth outlook so a core exposure should still be retained given that event risk still remains high regarding the European debt crisis.

However, against this, now is not the time to be boosting core country sovereign bond exposures. They have already rallied hard and the scope for further falls in yields, which would be necessary to provide decent capital growth and hence returns, is limited. By contrast, better medium term return opportunities exist elsewhere for investors:

• Investment grade corporate bonds in Australia are yielding around 6.5% on average.
• Australian listed real estate trusts are yielding around 6.2%.
• Australian shares are yielding 6.3% once franking credits are added in.

With the global growth outlook improving and tail risks associated with a blow up in Europe receding somewhat, the prospects for these assets has improved compared to sovereign bonds in core countries which now have very low yields and hence more constrained return prospects.
Within fixed interest, Australian bonds with their higher yields probably make them better value than global bonds.

So overall, while there is still a strong case to include sovereign bonds in a multi asset portfolio as a diversifier, it makes sense to lighten exposures in favour of assets providing better yields and return prospects.

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