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Bond market down but not out despite hitting 30-year low

Glenn Freeman  |  25 Jan 2017Text size  Decrease  Increase  |  

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In the face of extreme uncertainty, particularly since the latter stages of 2016, the value of taking a longer-term approach versus trying to time the market is paramount.

 

The declining value of fixed-income portfolios through the final quarter of  2016 was a sharp contrast to the buoyant returns equity investors enjoyed--somewhat unexpectedly--over the same period.

Brad Bugg, head of multi-asset income, Asia Pacific, Morningstar Investment Management, notes that many investors will have been shocked when looking at their portfolio statements. This is particularly true for those with conservatively-skewed investment portfolios.

"As we enter 2017, some investors will be looking at their investment statements and will notice that their portfolios have fallen in value over the last quarter. The reason for this has been the dramatic sell-off in bonds, triggered by a market now looking to higher bond yields on the back of increased expectations for both growth and inflation," Bugg says.

In Australia, the 10-year bond yield has risen from 1.95 per cent at the start of the quarter, to close at 2.77 per cent.

"Consequently, the value of these bonds has fallen, as bond yields and prices move in opposite directions, all things equal," he says.

"In this scenario, a diversified multi-asset portfolio that is traditionally structured with 30 per cent in equities and 70 per cent in fixed income will naturally find it hard when bond prices fall, and this was certainly the case last quarter."

Outside the norm

Even investors cautiously positioned, with high allocations to cash, still suffered "due to the broader market coming under fierce selling pressure". According to Bugg, this was by no means a typical sell-off for bonds.

"To put this into a historical context, the four months from the end of August to year end was arguably one of the worst periods ever in the nearly 30-year recorded history. Bond investors had no place to hide, with Australian bonds falling 3.1 per cent from peak to trough and currency-hedged global bonds down 2.5 per cent," he says.

In addition to bonds creating a considerable drag on performance for conservative investors, weakness was also seen in other interest-rate-sensitive investments, "particularly Australian listed property, even though we continue to hold much lower allocations to these assets than normal," Bugg says.

While numerous commentators point towards the current period of volatility as "black swan" events that are entirely unprecedented, Morningstar's view is that these sudden shifts are inevitable.

"The adjustments are also often sharp and quick as market participants try to adjust to the new environment, which in this case sees the market worried that President Trump's new policies will result in the need for much higher interest rates, even after the adjustment seen late last year," Bugg says.

"Therefore, trying to time the market is not something we try to do. Instead, we look to take a longer-term approach and focus on those segments of the market offering the best reward for risk at any point in time."

He highlights Morningstar's fundamentally-driven valuation process, which is employed "to identify where the best long-term value lies, and not trying to pick the winners over the next three, six or even 12 months."

While market participants were rapidly shifting out of fixed-income exposures in the second-half of 2016, Bugg says the "lens of our process provides a somewhat different view to that taken by the other market participants over the course of 2016".

"We are now gradually looking to increase our exposure to bonds given they now represent much better value. We have also looked to steadily increase our inflation-linked bonds position to protect against the risk of higher inflation.

"These positions have and will be largely funded by cash, but even post these moves, cash levels will remain elevated as despite recent moves, bond yields are still very low in a historical sense."

Don't follow the pack

Bugg suggests that increasing  portfolio exposure to bonds in the current context of higher yields will add a greater level of resilience.

"We are confident that were one, or even a few of a long list of potential risks (European elections, trade wars) to materialise, the recently increased bond holdings should offer good protection," he says.

"If the events of 2016 have taught us anything, it is to expect the unexpected, and following the broader market is not always the best strategy.

"We continue to believe employing a robust and repeatable investment process that acknowledges and adapts to structural shifts in an intelligent and pragmatic manner remains the key to identifying those opportunities providing the best reward for risk."

More from Morningstar

No shortage of knock-out punches for markets in 2017

Why SMSFs should start preparing for 30 June now

 

Glenn Freeman is Morningstar's senior editor.

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