INVESTMENT COMMENTARY

Where to for the role of defensive assets in a diversified portfolio?

David van Schaardenburg discusses the future of investment bonds and alternative options for conservative investors going forward.

The financial impact from Covid-19 is forcing investors and their advisers to confront a range of issues and scenarios that most never imagined could occur.

As central banks pursue unconventional monetary policies aimed at limiting the depth of impact of the Covid-19 induced recession now upon us, one of these issues is the record low interest rates on defensive assets like bonds and cash.

Return is the reward for delaying consumption, otherwise known as saving. But when long-term investor return forecasts for an asset class are close to zero then it’s not unreasonable to expect rational investors to choose to allocate their funds to other asset classes. This, in part, could explain why investments like property and equities performed better in the last few months than was expected in March as the globe went into Covid-19 induced shutdowns.

Over the last decade bond markets both globally and in New Zealand have been a stellar performer returning consistently between 4% and 8% per annum with an annual average (pre-tax/fees) return between 5% and 6%.1 A great return for a relatively stable lower risk asset class forming a large part of a defensive and balanced investor portfolio. However, a chunk of that return was derived from the capital gains made as bond yields fell, getting us to where we are today.

With forecast returns on investment grade bonds looking close to zero or worse for the next decade, what worked yesterday is probably not going to work tomorrow. Consider this:

The most commonly used global bond benchmark – as at June 30, 2020, the Barclays Global Aggregate Bond Index when hedged back to NZ dollars has a pre-tax yield of 1.07%. It has a duration of over seven years.

Similarly, the NZ Corporate Bond Index has a yield of 1.00% pre-tax with a duration close to three years.

While this prospect must be highly concerning for bond fund managers, advisers managing asset allocation for clients no longer have the luxury of allocating to bonds with the expectation this asset class (after costs) will deliver a low risk return well above bank term deposits even as the latter reaches record low levels.

It is also a concern for KiwiSaver members who are in funds which allocate on average 48% of their KiwiSaver account to bonds and cash2, according to Morningstar.

This is not just a New Zealand issue. The traditional 60/40 equities/bond “balanced” portfolio commonly used in the US as a benchmark for retirement investing is set to have lower future returns with retirees having to look at other options to position the 40% defensive portion of the portfolio to get returns back up to an acceptable level.

What are the potential solutions?

01

Sooner rather than later, bond fund managers are going to be forced to take an axe to their management fees. Defensive managed fund management costs range from 0.3% to 1.6% per annum averaging at 0.89%3. So, for many investors, in the absence of capital gains from bond yields falling further, there won’t be much left for bond fund investors post the deduction of management fees.

“With forecast returns on investment grade bonds looking close to zero or worse for the next decade, what worked yesterday is probably not going to work tomorrow.”

“Sooner rather than later, bond fund managers are going to be forced to take an axe to their management fees.”

02

03

04

It’s expected bond managers may offer more risky portfolios (from a credit perspective) than their return benchmarks plus increasingly allocate to hybrid and structured debt. This does have volatility and liquidity implications which we clearly saw in March 2020 when the spread between higher risk debt issues widened out leading to many bond funds materially underperforming their benchmarks in Q1 2020.

The aggregate size of active positions in bond funds can be expected to increase including duration relative to benchmarks and greater concentration of individual positions.

Investors can purchase bonds directly rather than invest in this asset class through managed funds, with their financial adviser’s help.

Implications for investment advisers of near zero investor returns from defensive assets being:

01

02

03

04

Advisers will need to be able to demonstrate how the fee they are charging clients is adding value.

Client appetite for defensive assets will continue to decline.

The need to find higher risk substitutes for bond funds within the client’s risk appetite.

A sound knowledge base and expertise required to understand and analyse the additional risks of corporate and other types of bonds.

The global financial crisis (GFC) exposed a wide gap in understanding the inherent risks in structured debt investments between investment managers, investment advisers and investors. Nobody wants to see a similar repeat of the investor losses experienced then. However, free lunches in investing are rare so for increased forecast returns, more investment risk is likely to be required. This is an important discussion to have with your financial adviser.

What are potential substitutes for the role that low risk bond allocations have traditionally played in a diversified portfolio?

01

Stay with bonds but take on more credit risk by moving out beyond investment grade bonds. This can add 2% to 4% to ongoing income yields but carries more risk of defaults and return volatility. These risks can be better managed through a diversified high yield fund than investing directly.

02

03

High yield shares. As an example, the Smartshares S&P/NZX 50 High Dividend Index ETF had a trailing 12-month gross dividend yield of 5.87% at July 31, 2020 with net of charges gross yield of 5.33%. Dividends can go up and down as will share values so not the same stability as you’d expect from investment grade bonds.

The traditional Kiwi income favourite – property. An equal weighted NZ listed property portfolio as at August 1, 2020 is forecast to deliver a pre-tax yield of 5.5% for a 33% top rate tax payer. This comes with some uncertainty on dividends and property valuations in a Covid-19 world but they do have the potential to grow income over time.

It seems inevitable the conservative end of investors, working with their advisers, are going to have to seriously consider taking on more investment risk or conversely take on the risk of locking themselves long-term into a very low portfolio return. At the end of the day, as previously mentioned there is no free lunch. Higher yield equates to higher risk.

If you have any questions relating to this article or investment in general, contact the Findex wealth advice team at www.findex.co.nz A

David van Schaardenburg is a Senior Partner, Wealth Management at Findex. An Adviser Disclosure Statement is available on request and free of charge. www.goodreturns.co.nz/disclaimers

1 Barclays Global Aggregate Bond Index hedged to NZ Dollars. Bloomberg NZ Bond Credit 0+ Yr Index. Both indices for decade 30/6/2010 to 30/6/2020. 2 Source: Morningstar KiwiSaver survey June 30, 2020 3 Source: Sorted Smart Investor