INVESTMENT COMMENTARY

BY DAVID VAN SCHAARDENBURG

When Ian Fleming was thinking of a name for the central character of his thriller spy novels amongst the range of theories was that he sought a name which would be deadly dull and unremembered. Hence the surname “Bond”. As a member of the famed merchant banking family, most notable for his grandfather founding Robert Fleming and Co, Ian Fleming most likely had a view that bonds were dependable and boring delivering a steady return to investors with little risk.

If one looks at bond index performances for most of the last 35 years, Fleming was right.

Since the high inflation era of the 1970s and 1980s successful central bank monetary policy has driven down inflation, bond yields and ultimately interest rates. Over these decades bond investors have enjoyed both relatively high (to today) bond coupon payments and with relentlessly declining yields, capital gains. The last part of this decline to new record low interest was driven by the unexpected event of a global pandemic. Bonds have been boring yet great performers for the last 35 years. A la James?

However, in the latter part of Q3 2020, with US 10-year Treasury yields reaching 0.5% and NZ government bond yields similar, doubt was growing in my mind that bonds would in future perform the same valued role they had performed for decades. This is especially apparent for conservative and balanced portfolios where bonds made up more than 50% of the investments.

I’ll take a stronger view. There has been for the last year no logical reason to hold bonds in the portfolio of any investor. For investors with short-term horizons, cash even at near nil interest rates is a better risk. For investors with five-year plus horizons, I prefer shares especially those with good free cash flow (and therefore ability to reinvest and/or pay dividends) over virtually any bond investment.

This is a classic example of where historic performance is no predictor of future performance!

The US has had a commonly held view that a portfolio 60% shares and 40% bonds is the optimal asset allocation for most retirees. In New Zealand, KiwiSaver default funds are required to hold a minimum of 75% in bonds or cash (soon to be 50%) while the typical balanced fund will have a benchmark asset allocation c. 50% shares and property/50% bonds and cash.

As stated in my last article, the standard investor risk assessment process biases many investors, especially those close to or in retirement, towards being a conservative or balanced risk profile many likely preferring this status without fully understanding the longterm return and financial planning implications.

The lower return impact on such portfolios is now accentuated by the negative contribution their material allocation to bonds is likely to achieve for at least the next five years.

Having been an adherent to the validity of conventional asset allocation across all risk profiles, I now find myself in a position of believing: “For most investors mid to low-risk asset allocation strategies make no sense.”

While in some ways it’s easier to cling to convention and the past ways that have served clients well, this is no longer the case.

By not driving change fund managers and investment advisers might be the winners short term by maintaining their (high) fees on low to medium risk portfolios where 50% plus of the assets are delivering nix. But this has longerterm business risks as disappointed clients increasingly turn to alternative investment approaches.

While a short-term microcosm, we are already seeing the negative effect on investor returns from the start of the normalising of bond yields.

Taking the returns (post tax, fees) of two funds in the period from September 30, 2020, close to the time of bond yield lows, up to the end of February 2021. On one side a NZ government bond fund the other a NZ share fund.

With bond yields starting to rise over this period, the NZ bond fund achieved a negative return of 7.5% while the NZ share fund had a positive return of 3.3%. Clearly bonds are no longer “safe and boring”.

Extrapolating this trend further.

By investing in a bond fund with a portfolio duration of five years, and assuming that inflation and risk premiums trend up over the next five years back to the long-term average, the portfolio yield will rise to around 250bps above today’s yield levels. This equates to additional capital losses of 12.5% for such a portfolio more than offsetting post fees coupon payments from the bonds.

Based on this example, conventional bond funds will most likely deliver a negative return to investors over the next five years to add to the losses of the last six months.

Expect your conservative and balanced clients to not be too thrilled by this prospect.

I expect the growing trend we have seen in the US, that is to cut out the middle man (read fund managers and/or investment advisers), to grow exponentially in New Zealand. This growth trend I expect to accelerate for four reasons.

• Investment advisers struggling to shift the thinking of their existing (read older) client base.

• An inability of most fund managers to efficiently reposition their clients to invest via bond-less portfolios.

• Financial regulations and supposed “best practice” pushing advisers to allocate clients into portfolios laden with bonds.

• Low to medium risk managed funds/ portfolios including KiwiSaver becoming synonymous with relatively high fees and low nominal performance.

If the above expectations come to bear, I expect a rising proportion of the next generations of near retirees to first explore the Hatch or Sharesies type of investing solution before talking to a financial adviser.

The cutting edge of the investment industry has clearly shifted towards new technologies facilitating low cost, flexible and transparent direct investing. While there are risks in investors going alone, further improvements in these technologies especially in the area of robo-advice should further strengthen their appeal versus the relatively cumbersome and costly process (saddled by extra layers of regulation) of using a financial adviser.

First, throw the conventional “rule book” on risk profiling and asset allocation out the window.

Second, have a strategy to engage with clients to help them evolve their understanding of how today is different from the past 30 years.

Third, don’t blindly rely on fund managers to “fix” the problem. This doesn’t mean they lack the capability. But in most circumstances they are restricted in how dynamic they can be in altering portfolio composition in the absence of material rewrites of their offering documents. Which is a significant process and takes time.

Find out how they are dealing with this new dilemma then apply your collective learnings to client strategies.

Clients pay you to add objective insight and improve the probability they will achieve their financial objectives. It’s also critically important they understand how and why you are recommending change especially a material one.

Real opportunity exists for advisers to add or subtract value to clients over the next five years. Unfortunately, this will not be achieved by following established conventions. A

David van Schaardenburg is an independent investment analyst.