However, the returns on fixed income have actually been superior to the returns on term deposits over the past 10 years. Given the current economic environment both globally and domestically, cash rates are likely to remain lower for longer, which should keep bond prices higher and term deposit rates lower. As a result, Australian investors may want to reassess their low exposure to fixed income. 

Q: Is Australia unusual in its preference for cash vs fixed income?

A: The simple answer is yes. Historically, Australian investors have preferred cash rather than fixed income as the default position for the defensive asset holding in their investment portfolios. Although US investors have held around the same amount of equities as an Australian investor, instead of cash they held more of their portfolios in fixed income.

Pension Fund Asset Allocation in Selected OECD Countries, 2012

 Source: OECD Global Pension Statistics

The “Other” category includes loans, land and buildings, unallocated insurance contracts, hedge funds, private equity funds, structured products, other mutual funds (i.e. not invested in cash, bills and bonds, shares or land and buildings) and other investments.

For Australia, Source: Australian Bureau of Statistics. The high value for the “Other” category is driven mainly by net equity of pension life office reserves (14% of total investment).
For Canada, the high value for the “Other” category is driven mainly by other investments of mutual funds (15% of total investment).
For Japan, Source: Bank of Japan. The high value for the “Other” category is driven mainly by accounts payable and receivable (22% of total investment) and outward investments in securities (21% of total investment).

For Germany, the high value for the “Other” category is driven mainly by loans (18% of total investment) and other investments of mutual funds (17% of total investment).

 Q: What are the reasons for this disparity?

A: It is partly due to a lack of familiarity with fixed income in the Australian market and partly because historically Australian cash rates were high, leaving very little premium between the cash rate and the yield on the 10-year bond. By contrast, US investors historically have been paid to hold 10-year bonds and so have been incentivised to hold long duration assets.

Q: What was the effect on Australian investors of holding cash rather than fixed income?

A: Given the high yields available on Australian term deposits, the decision to hold them rather than bonds may be seen as rational and appropriate in a high inflation environment. However, such  investors missed out on the major benefit of holding high quality bonds – the negative correlation they provide to equities. This particularly came to light in the GFC when equity prices collapsed and many Australian investors had no fixed income exposure to offset the negative returns from equities. In fact, as cash rates fell to help stabilise the economy, cash holdings performed poorly compared with fixed income.

Q: What’s the difference in long-term returns between fixed income and term deposits?

A: The returns on fixed income have surpassed term deposits over the longer term despite the fact the Australian yield curve has been so flat over the past 10 years.  Although investors in cash believed they were investing in an asset class which was offering 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. When choosing where to allocate funds, it seems that investors are more concerned about ex ante returns than the returns they would have got from an asset class they don’t own.

Bonds outperform term deposits over the long term

Source: Mercer Insight; RBA (data reference: FRDIRBTD10KAR)

Dividends and distributions are reinvested. Returns are gross (pre fees, pre tax) and assume reinvestment of distributions.
*Term deposit return is the average rate on $10,000 term deposits across all terms at the five largest banks, including their advertised ‘specials’ and regular rates (using the monthly effective rate)

Q: Will we see domestic investors looking more closely at fixed income for their liquid or defensive asset class holdings?

In our view, they should but the problem is that investors are still scared off by the fact that bond markets have had a 20-year rally and rates must return to their normal levels from the current historically low yields.

Bond markets have had a 20-year rally in Australia and this has been due to the fact the neutral rate for cash has fallen as inflation has fallen. The Reserve Bank of Australia (RBA) has an inflation target of 2-3%. The success of the RBA in achieving its target has resulted in the financial market viewing it as credible. Since longer-term bonds use this as a realistic inflation level, it has lowered the risk premium around future inflation levels helping to lower bond yields and raise prices.

Q: Bond yields are historically low: is this likely to continue?

A: Central banks globally have intervened to lower bond rates. They could not cut cash rates below zero and so embarked on unconventional policies, such as quantitative easing (QE) to help repair their economies. QE has depressed real rates and term premiums globally. Many of these programmes have stopped or are being tapered. In 2013, US rates rose by 100 bps on the back of the Federal Reserve’s tapering of QE. However, the Fed still holds a vast quantity of fixed income securities on its balance sheet. This is not just holding up bond prices (therefore keeping yields low) but also bolstering all risky assets, including equities.  While QE persists, bond yields will remain depressed.

As we have stated previously, Tyndall views the new neutral rate for cash as being around 4.0%, which would imply a normal rate for the 10-year bond yield of around 5.0% (100 bps above its current level of 4.0%).  With the cash rate at 2.5%, even the current low bond yields are still providing a better return than cash.

Q: What will be the impact on Australia of lower rates for longer?

Australia’s household debt to disposable income is at record highs at around 148%[1]. With the decline in the terms of trade, low wages and low returns, income growth will remain low. As a result, monetary policy will have a stronger impact on the economy and won’t require large increases in interest rates to have the desired effect on the economy as we have seen in previous cycles. With cash rates low and likely to remain low and term deposit rates falling, Australian investors may start considering increasing their exposure to fixed income.

The risk of being so underinvested is a major one that is often ignored and leaves investors exposed not only to a potential fall in the cash rate but also the current low interest rate environment.  Apart from bonds’ defensive qualities and negative correlation to equities, the longer term threat of low inflation and the inability of central banks to adequately deal with it also warrants an allocation to bonds, in our opinion.

[1] Source: Reserve Bank of Australia, table E2, http://www.rba.gov.au/statistics/tables/index.html.

By Roger Bridges, Head of Fixed Income Strategy, Tyndall AM

———–

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.

The Tyndall Australian Bond Fund (ARSN 098 736 255) is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL 229664, a related entity of Tyndall AM.  Potential investors should obtain their own independent advice and consider the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest.

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That was in the past. Now Aussie consumers are more cautious on going into debt, restraining demand for existing homes. Home prices were broadly flat in 2012 after falling 3.8 per cent in 2011 and rising 5.4 per cent in 2010.

But while Aussies are cautious on going into debt, population is still rising while home building has remained weak. So rents are still rising and so are investment returns on property. Property returns grew by around 4 per cent in 2012, just ahead of cash, but well short on the near 19 per cent growth of sharemarket returns.

CommSec expects that national home prices will rise around 3 per cent in 2012 with total returns up around 7 per cent. Aussies should grow more confident about taking out loans and buying real estate in 2013 although home building is also expected to grow in line with underlying demand.

What do the figures show?
The RP Data-Rismark Hedonic Australian Home Value index of capital city home prices fell by 0.3 per cent in December and was down by 1.2 per cent in the in the December quarter. Over 2012 home prices fell by 0.4 per cent.

In December, house prices fell by 0.1 per cent with apartment prices down by 1.1 per cent. Over 2012, house prices are down 0.5 per cent while apartment prices were up 0.5 per cent.

The average Australian capital city house price (median price based on settled sales over quarter) was $510,000 and the average unit price was $432,000.

Dwelling prices rose in four of the eight capital cities in December: Hobart (up 0.7 per cent), Melbourne (up 0.5 per cent), Perth (up 0.3 per cent) and Adelaide (up 0.1 per cent). Prices fell the most in Darwin (down 2.5 per cent), followed by Canberra and Sydney (both down 1.0 per cent) and Brisbane (down 0.3 per cent).

Home prices were higher than a year ago in three of the eight capital cities: Darwin (up 8.9 per cent), Sydney (up 1.5 per cent), Perth (up 0.8 per cent). Prices fell most in Melbourne (down 2.9 per cent) followed by Brisbane and Adelaide (both down 0.8 per cent), Canberra (down 0.3 per cent) and Hobart (down 0.1 per cent).

Total returns on capital city houses were up 3.7 per cent on a year earlier and units were up 5.6 per cent.

What is the importance of the economic data?
The RP Data-Rismark Hedonic Australian Home Value Index is based on Australia’s biggest property database (more than 312,000 sales during 2011). Unlike the ABS Index, which excludes terraces, semi-detached homes and apartments, the RP Data-Rismark Hedonic Index includes all properties. Home prices are an important driver of wealth and spending.

What are the implications for interest rates and investors?
With home prices flat, manufacturing contracting, inflation contained and the global economy still creating uncertainties, the Reserve Bank will lean in favour of providing more monetary stimulus. But we are close to an inflexion point. If US policymakers fundamentally deal with budget deficit and government debt issues, the outlook will become clearer and more positive. Australian consumers and businesses largely lack the confidence to embrace the opportunities that exist.

The outlook for the housing market is improving. Population is lifting but the supply of homes has not kept pace. So rental markets still generally remain tight with rents rising. Budding owner-occupiers of homes have largely sought to utilise existing housing stock (shared rental; young people living at home with parents for a longer period) than buy or build homes. If confidence improves as we expect in 2013, demand for new and existing properties will rise.

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“How could you justify charging a 1% MER for holding 10% in cash for the past 6 months?” or “Are you not paid to pick stocks?” or again “Are you not overstepping the boundaries of your mandate and going against your investors’ will by holding cash?”.

The history of investment management is certainly not short on managers who charged a lot and delivered little, but our insatiable appetite for contrarian views made us wonder whether there was another side to this debate. As it turns out, Warren Buffett certainly believes so.

In a recent interview with Canadian newspaper The Globe and Mail, Alice Schroeder, author of The Snowball: Warren Buffett and the Business of Life and an avid follower of the Oracle from Omaha for years prior to becoming his biographer, declared:

“He thinks of cash differently than the conventional investors. This is one of the most important things I learned from him: the optionality of cash. He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price.”

In Buffett’s mind, holding cash is a sound, active, investment decision. It stems from the belief that one or several assets will lose value in the near future and will then become attractive buys. Holding cash is like buying a call option because the only two possible end results are identical: either the investor was wrong, in which case the option expires and the loss is limited to the price already paid for the option, or the investor is vindicated and he or she can now hold the desired asset from an advantageous entry point.

However, one might reasonably argue that Buffett’s investment objectives and capabilities are not comparable to those of the average Australian retail investor. We therefore need to establish whether the optionality of cash is a concept that can be successfully implemented for the latter. If cash is to be likened to a call option, our first step should be to price the said option. Any conventional method of option pricing (for example, the Black and Scholes model) is not applicable here since our cash option has no defined underlying asset, expiration date or strike price. Instead, a sensible approach could be to deduct the return on cash from the opportunity cost, i.e. from how much I am missing out on by not investing elsewhere. For the sake of simplification, let’s agree that this “elsewhere” is the rest of my portfolio. The cost of holding cash for a period of time is therefore equal to the return on my portfolio over this time minus the return on cash. The first conclusion we can immediately draw from this equation is that the price of holding cash will change over time, and that certain market environments will render cash “cheap” or “expensive”. But more on that later.

Second, let’s consider the expected return from holding cash. The main driver of this return should be the difference in price for the asset(s) I will be buying between now and then. In other words, the return on cash, while a contributor to the return, should not be the key consideration. Investing in cash should not be prompted by high term deposit rates, which merely facilitate the trade by reducing its cost. Holding cash is a sound investment decision only when it can be linked to a forecasted drop on a given asset and its subsequent attractiveness.

We have stated that certain market environments are more conducive to maintaining a substantial portfolio allocation to cash, and we believe that we currently are in such an environment. Term deposit rates in Australia, while on a downward slope, remain high by historical and international standards. Expected returns on traditional asset classes have been revised downward in light of disappointing performance over the past 5 years. Cash is definitely cheap. The challenge is now to position a portfolio so it can take advantage of such opportunities. 

Since 2008, van Eyk has progressively shifted its portfolios from a traditional structure (Model A below) towards a structure where core managers are given wider constraints (Model B), which we believe is more appropriate in the range bound but volatile market environment that we envisage during the next few years. We perceive the need to be more proactive on how we allocate to satellite asset classes, including cash, as markets will create valuation-driven opportunities.

When considered through this lens, as a simple cost/benefit analysis, it is clear that retail investors can benefit from using cash in this way. 

The optionality of cash, so prized by Warren Buffett, is indeed available to all.

This article was first published in the November 2012 issue of the van Eyk View. To download the iPad app, go to
http://itunes.apple.com/au/app/the-van-eyk-view/id476210180

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“While all available research shows that investors have been focused on cash as the best safe haven to protect capital, falling interest rates are making such a strategy increasingly unsound. 

“Having some investment in cash products such as term deposits may be sensible for some investors, but it should always be as part of a balanced diversification strategy. 

“Falling interest rates and inflation combine to reduce both the value of capital and income – exactly what investors seeking a ‘safe haven’ are trying to avoid,” he said. 

Mr Bryant said that an urgent rethink is needed by many investors to redefine what a ‘safe haven’ means to them and what the cost might be of the various options, as well as the opportunities other asset classes offer. 

“Now is not a good time to be over-invested in cash products.  They might offer surety of capital being repaid on a due date but the cost can be considerable, and this together with other factors shouldn’t be ignored by investors. 

“Ease of access, income stability, inflation protection, capital growth as well as security, can all be important to investors depending on their circumstances and financial needs,” he said. 

Mr Bryant says that investors need to understand circumstances change and at the moment an over-cautious approach – such as having all their savings in term deposits – now comes with a major opportunity cost. 

“For example, fixed interest funds have performed better than term deposits in the last four years (since the flight to cash started in earnest) and equities have given better yields than term deposits over the same period, particularly for investors on higher tax rates. 

“Indeed, an investor who put some of their wealth in bank shares in June 2008 rather than depositing all their money in interest-bearing term accounts, would have received excellent yield as well as capital growth. 

“For example, if an investor had deposited $10,000 in a one-year term deposit in June 2008, and reinvested maturity proceeds along the way, this would have increased in value to $12,519 by June 2012. However, if an investor bought $10,000 of CBA shares in June 2008 it would be worth $18,819 including franking credits, in June 2012 – and we have seen even more increases in sharemarket value in the last couple of months.” 

Mr Bryant added that diversification is always the best approach no matter what the economic situation is. 

“There is currently a notable degree of optimism in the main growth asset classes that investors should factor into any portfolio rebalancing. 

“While there is still volatility in equity markets, and although markets are still experiencing frequent falls, there appears to be the beginning of an underlying trend upwards,” he said. 

“In addition, property markets appear to be shaking off the stagnancy of recent years as an inability to satisfy future demand is becoming apparent in some sectors, for example office, healthcare and retirement living. 

“Investors who have remained in cash over the last several years now need to reassess their priorities as they face falling returns coupled with an erosion of capital value. 

“Moving to a more diversified investment approach at the moment is likely to provide the access, income stability, protection and capital growth that have become the priorities for many investors,” Mr Bryant said.

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• Just under half of financial assets at private sector companies are held in cash or deposits, while households are holding just over a quarter of their assets in cash and deposits.
• The high level of liquid assets is both positive and negative. Companies are well able to deal with the challenges posed by the volatile global financial conditions. But at what point does the level of cash become too much? It is easy to hold funds in liquid form of cash and deposits, but shareholders also want companies to be exploring opportunities to increase efficiency, productivity or growing organically or by acquisition.
• Australian consumers and superannuation funds are also maintaining extraordinarily high holdings of cash and deposits. In fact super funds are holding almost double the “normal” cash holdings with the proportion of assets sitting just over 14 per cent.

To read the full report from CommSec, click here.

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