REGULARS | INVESTMENT COMMENTARY
Where to for the role of defensive assets in a diversified portfolio? David van Schaardenburg discusses the future of investment bonds and alternative options for conservative investors going forward.
T
he financial impact from Covid-19 is forcing investors and their advisers to confront a range of issues and scenarios that most never imagined could occur. As central banks pursue unconventional monetary policies aimed at limiting the depth of impact of the Covid-19 induced recession now upon us, one of these issues is the record low interest rates on defensive assets like bonds and cash. Return is the reward for delaying consumption, otherwise known as saving. But when long-term investor return forecasts for an asset class are close to zero then it’s not unreasonable to expect rational investors to choose to allocate their funds to other asset classes. This, in part, could explain why investments like property and equities performed better in the last few months than was expected in March as the globe went into Covid-19 induced shutdowns. Over the last decade bond markets both globally and in New Zealand have been a stellar performer returning consistently between 4% and 8% per annum with an annual average (pre-tax/fees) return between 5% and 6%.1 A great return for a relatively stable lower risk asset class 028 | ASSET OCTOBER 2020
forming a large part of a defensive and balanced investor portfolio. However, a chunk of that return was derived from the capital gains made as bond yields fell, getting us to where we are today. With forecast returns on investment grade bonds looking close to zero or worse for the next decade, what worked yesterday is probably not going to work tomorrow. Consider this: •
The most commonly used global bond benchmark – as at June 30, 2020, the Barclays Global Aggregate Bond Index when hedged back to NZ dollars has a pre-tax yield of 1.07%. It has a duration of over seven years.
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Similarly, the NZ Corporate Bond Index has a yield of 1.00% pre-tax with a duration close to three years.
While this prospect must be highly concerning for bond fund managers, advisers managing asset allocation for clients no longer have the luxury of allocating to bonds with the expectation this asset class (after costs) will deliver a low risk return well above bank term deposits even as the latter reaches record low levels.
It is also a concern for KiwiSaver members who are in funds which allocate on average 48% of their KiwiSaver account to bonds and cash2, according to Morningstar. This is not just a New Zealand issue. The traditional 60/40 equities/bond “balanced” portfolio commonly used in the US as a benchmark for retirement investing is set to have lower future returns with retirees having to look at other options to position the 40% defensive portion of the portfolio to get returns back up to an acceptable level.
What are the potential solutions? 01 Sooner rather than later, bond fund managers are going to be forced to take an axe to their management fees. Defensive managed fund management costs range from 0.3% to 1.6% per annum averaging at 0.89%3. So, for many investors, in the absence of capital gains from bond yields falling further, there won’t be much left for bond fund investors post the deduction of management fees.
