Investors are too narrow in thinking of fixed-income as just term deposits, hybrids or government bonds, and should be widening their view to take in corporate bonds as well despite the re-emergence of the European woes.
Low yields in the “major” foreign government bonds had seen global investors searching for yield, while simultaneously avoiding bonds that had some chance of defaulting, Altius Asset Management’s portfolio manager Chris Dickman said.
The Reserve Bank of Australia cut cash rates recently and so the market had already factored in a cash rate of 2.50 per cent by November.
“This means that government bonds will start to struggle if not further boosted by a European inspired ‘event’ or a significant deterioration in the prospects for Australia’s largest trading partner, China,” Dickman said.
“Government bonds continue to be seen as a ‘safe haven’ but demand for good quality corporate bonds remains strong and should be seen as an attractive option by investors.”
Investors in defensive assets should look at some key strategies that might pay off in this volatile environment.
Diversification was crucial, Dickman said.
“This means an appropriate spread of mostly high-quality credit exposures and looking at both the yield and the ongoing return,” he said.
“Just because something has a low yield, it shouldn’t be ignored because the capital gains from falling yields for longer-duration bonds could still mean a handsome return.”
For example, one reason for the huge growth in term deposits in recent years was that investors chose the 5.5 per cent term deposit return over a 4.5 per cent bond.
But some term deposit yields had fallen by 0.5 per cent in line with the cash rate cut, while a five-year Commonwealth Bond had fallen by about 1.2 per cent since mid-March, equating to a return over that short period of time of around 5.7 per cent versus less than 1 per cent from the term deposit.
Investors should also be selective about when to embrace duration and government debt as valuation became important in this environment, Dickman added.
Bond yields were likely to normalise gradually during the next year or so, “although with considerable volatility”, and “credit will likely shine as relatively solid growth prospects, and balance sheet management, support corporate profitability,” he said.
“The re-emergence of the European woes in recent months has implications for those corporates who will be seeking to raise funding over the next few months.
“While credit issuance has recently declined on the back of the European situation, high quality corporates may consider accessing the corporate bond market directly, as an alternative to bank loans.”
If this occurred, it may have liquidity and diversification benefits for bond investors over the medium to long term.
