Rising interest rates may well mean short-term pain for bondholders, but a passive portfolio of bonds will benefit from higher rates in the long term, says Vanguard.
Speaking at an ETF adviser roadshow in Sydney, Vanguard head of investment strategy Jeff Johnson tackled what he called the 'myth' that higher interest rates are necessarily a "bad thing for investors".
First, Mr Johnson took aim at the contention that interest rates are "certain" to rise around the world.
"There’s no question that in certain parts of the world there is upward pressure on interest rates – in fact when we look back we’re a bit surprised that the US Federal Reserve in part hasn’t raised rates already," he said.
But weak growth and "nascent" inflation in Europe and Japan – as well as quantitative easing programs – make interest hikes unlikely in those countries soon.
Australia is in a "subdued growth environment" as a result of a slower Chinese economy, lower commodity prices and a "rebalancing" economy.
"There have been two interest rate cuts by the RBA so far this year. It's unclear what the next direction might be, but there is some possibility that rates could even head lower from here.
"Certainly in China the main concern is that they could be going through a hard landing. They’ve been cutting rates," Mr Johnson said.
Even if global interest rates do head "markedly higher from here", bonds and bond ETFs have a "natural built-in mechanism" to adapt to a higher interest rate environment, he explained.
"As bonds in the portfolio mature ... the proceeds are reinvested at higher prevailing yields based on where the market has moved," he said.
"What that means is that over time there’s an adjustment period, and after about a 3-5 year period investors are actually earning more in total return terms than if interest rates hadn’t changed at all.
"And over a 7- or 10-year period investors are substantially better off from an environment of higher yields," Mr Johnson said.
While he acknowledged investors must cope with a short-term adjustment period, it is important to put it into context.
"If markets are strong enough to withstand an interest rate increase like that, there’s probably strong growth happening globally and other elements of the portfolio could be advancing very strongly."
The comments came as Vanguard announced the launch of two new international fixed income ETFs (providing exposure to government bonds and credit securities) in the final quarter of 2015.
Vanguard will also launch an Asian equities (ex-Japan) ETF and a European equities ETF on the ASX by the end of the year.
Economists agree that the Reserve Bank is likely to remain in inflation fighting mode until December. ...