Jan 23

Thoughts on the outlook for bonds

Bonds were not surprisingly the highest performing asset class in 2008. Advisers can expect increased promotion of bonds by BDMs and fund managers and the issuance of new products (eg the new Vanguard Australian Government Bond Index Fund). What is our view?

· Australian Bonds: Neutral, with a likely move to underweight
· International Bonds : Underweight

The headline in the recent Morningstar performance league table was something along the lines of “Australian Bonds best performing asset class since 1992” with a return of 14.95%, but what about 2009?

Last week, Vanguard launched their Australian Government Bond Index fund after the “Commonwealth Bond >10 years Accumulation index“ had an enormous return of 27.72% in 2008. However with government bond yields currently at their lowest for many many years (and therefore their highest price) is this the latest bubble?

At the time of writing (January 27), Australian government bond yields that mature between 1 and 15 years range in yields between 2.54% and 4.16% so if held to maturity then these yields are the highest returns that can be expected. However, what is in favour of the bond investor is that it is possible for bond yields to fall much further. Australian yields are much higher than those overseas where the 10 year US Government bond trades at a yield of 2.64% and in the UK, 3.70% (compared to Australia’s 4.16%). With China’s economic growth slowing rapidly, it is looking increasingly likely that Australia will go into recession and this could well result in lower bond yields and therefore higher prices. Overall, the combination of record high bond prices with an economy under pressure means the outlook for Australian bonds is “Neutral” with an expected next move as “Underweight” … but not quite yet.

Global bond prices, on the other hand, have very little room to increase. US cash rates are effectively at zero, so too is Japan, and Europe isn’t far behind. As already mentioned the longer term yields are also very low. After a solid 2008 annual return for hedged global bonds of around 13.5% (according to the Citigroup World Government Bond Index), the downside risks appear far greater than the upside potential so the outlook for hedged International bonds is “Underweight”.

Bonds typically perform best in a deflationary environment whereby a dollar today is worth less than a dollar tomorrow. Should the outlook for the global economy move towards deflation then it is likely the outlook for bonds will be more positive than the current view.

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