Cam Watson, 12 February 2016

An investor recently told me he had stopped buying bonds because he believed the fall in interest rates over recent years now meant they were too risky. He was buying shares instead.

I was flummoxed. His point of view raises some important issues. I didn’t have the gumption to respond to him at the time, so I will now.

If you dig a little deeper, it is probably not risk that is really driving his view, it is expected return.

Ten years ago the 90 day bank bill rate was 7.6%, today it is 2.7%. This decline in cash rates has flowed across bonds as well, and returns are much lower than they were pre the global financial crisis.

This investor is perhaps making the same mistake many investors make – he is setting his investment strategy by chasing returns, and ignoring risk. Shares have done well over recent years, dividend yields are reasonably high, and he is therefore switching his bonds for shares because they offer the potential for higher returns.

He is missing two issues. First, while headline or ‘nominal’ returns from bonds have fallen over the past decade, inflation has also fallen, meaning the underlying real return from fixed income is still reasonable. The net return, after accounting for tax and inflation is today only 0.8% less than it was 10 years ago. See table. And I am using a forecast annual inflation rate of 1.0% in these calculations. The current actual rate of inflation for calendar 2015 was just 0.1%. Using this figure would mean that real rates are virtually changed from 10 years ago.

Secondly, buying shares because bonds are ‘too risky’ is flawed thinking. As any finance textbook will tell you, shares are riskier than bonds.

There are a raft of riders to that statement given some bonds can be very high risk, but if you consider shares and a conventional bond (i.e. one with a maturity date and no subordination) issued by the same entity, the shares are riskier. Any dividend from the shares is discretionary and not fixed, the share price can be volatile (the last week or so provides a good example of this with some equity prices falling sharply), and shareholders rank last in any default situation. With a bond, the income is ‘fixed’ (that’s why we call bonds ‘fixed income’) for the term of the investment and on maturity the initial capital is repaid, assuming no credit problems.

It is a mistake, in our view, to set investment strategy on historical and perceived future return alone. Chasing high returns with no regard for risk is a recipe for disaster. The decision on how to split a portfolio between fixed income and shares should be driven by an investor’s objectives and their risk tolerance, not by chasing (nominal!) returns.

We have a unique situation at present where returns from all assets have been strong over the past 5 – 10 years, but are likely to be much lower over coming years. This return compression is an outcome of the unique economic situation we have had since the global financial crisis where inflation and growth have remained consistently low. Investors need to adjust their return expectations down for this new environment.

During this time, risk has been in hibernation as well. Shares and bonds, apart from the odd stutter, have performed well. Over the past five years New Zealand shares have returned 13.1%pa and local corporate bonds have returned 6.3%pa. This is just the sort of backdrop where memories of riskier times fade and investors start to feel comfortable taking on much more risk than perhaps they would have in more testing times.

The decision should never be between bonds or equities. Both should always be held in a portfolio. Our investment committee would never recommend a wholesale exit of one in favour of the other – that would infer that we have perfect foresight of what markets will do in future, which is not the case for any human being. Rather, they recommend only a modest ‘lean’ to one or the other depending on the relative outlook for each.

The market outlook is currently uncertain, as it always is and arguably more so now than in the past few years. The key to navigating uncertainty is diversification, and bonds have a vital role to play in this respect. When combined with shares and other growth assets, bonds provide a portfolio with stability of income and capital in volatile times.