Wednesday 15 March 2023 by Darryl Bruce Education (basics),Education

Bond Basics #1 – diversifying through fixed income investments

“You should own your age in bonds” was the view of Jack Bogle who was the founder of Vanguard Group. What he meant by this was that a 60-year-old should have roughly 60% of their investment portfolio in bonds. Internationally this is a mantra that is broadly followed, however every day I talk to investors that are underexposed to fixed income investments. The corollary being that they are over-exposed to cash, or more volatile asset classes such as equities.

To clarify, I do not expect a 60-year-old with no fixed income investments to immediately allocate 60% of their portfolio to bonds, however the thinking behind Jack Bogle’s comment is sound. The idea being, that as you get older your ability to withstand a major fall in capital is significantly reduced. So gradually moving towards a more defensive asset allocation as you age makes perfect sense.

When I first moved to Australia, I was surprised by the level of cash holdings that many people had in their portfolio. Cash is clearly a defensive asset, however given current returns on term deposits, investors are going backwards with inflation printing at 6.9% over the past 12 months. According to recent OECD figures, out of 41 countries, Australian pension funds have the fourth highest allocation to cash and the third lowest exposure to ‘bills and bonds’.

At the time I relocated to Australia in 2013 term deposits, and even at call cash, were offering reasonable returns. The case for holding an overweight position in cash when returns are higher than the last 3 years but still historically low is much harder to make. The place for bonds in investment portfolios has probably never been stronger given an all-investment grade portfolio can return well over 6%.

The same OECD study showed that Australian investors have the 6th largest exposure to equities. This allocation has no doubt served many well over the longer term (when they can cope with the volatility) however we know that these things move in cycles. Down swings can have a savage impact on portfolios especially for those that are retired and have minimal ability to replenish lost capital.

The chart below outlines the relative returns between the ASX200 (red line) and two different bond indices. The blue line is the Bloomberg AusBond Credit Index which broadly tracks the investment grade bond market. The green line is the Solactive FIIG Australian High Yield Index which tracks the high yield bond market. This chart, which goes back to March 2018, gives a very good overview of the differing experiences investors can expect in shares and bonds. Cash is not represented on this chart, but we all know that cash returns have been close to zero for 2020-2022 and have only recently risen to current levels.

The investment grade bond market (blue) has generated the lowest and most stable returns over the period. Investment grade bonds are typically issued by large companies that are household names and are financially very robust. The stability of the returns is impressive given the period that we have been through, especially the last year of the fastest rate hiking cycle in history. Also note the stability through the COVID period when the two riskier indices went down a lot in value.

The high yield bond market (green) has slightly outperformed the investment grade market over the period. The high yield market was also very stable except for during the midst of the COVID-19 crisis. High yield companies are often smaller and do not have the financial flexibility of investment grade companies.

During normal economic periods high yield is expected to outperform investment grade however during a crisis, such as COVID-19, high yield bonds will be more volatile albeit as demonstrated above, they have steadily recovered.

Finally, equities (red) have generated the highest and most volatile returns. Equities had a strong run up prior to COVID-19 and then a very sharp pull back eroding all the gains versus both investment grade and high yield bonds. They have recovered sharply again but where they go from here is anybody’s guess.

The key point to remember here is that bonds are not aiming to outperform equities. We are aiming to bring something different to an investment portfolio. People don’t leave their money in the bank because of the high returns, they leave it at the bank as it is seen as being safe and secure. Bonds offer a valuable middle ground for most portfolios, offering significantly higher returns than cash without the volatility of the returns that can be experienced in the equity market.