Back Bonds in 2019 for Capital Preservation

Fixed income investments may not be entirely immune from market volatility - but they do pay a coupon which helps to smooth returns

Glenn Freeman 14 January, 2019 | 12:28AM
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Glenn Freeman: I'd just like to start by saying Happy New Year John. This is the first video that I've shot for this year. So, welcome and thanks for joining us.

John Likos: Yeah. Thanks, Glenn. Happy New Year to yourself and to all the investors out there.

Freeman: Now, John, we are hearing a lot about volatility in equity markets, but we are talking today about fixed income. What's happening within that space? I mean, is 2019 going to be less or more risky for credit investors?

Likos: Yeah. Look, it's a good question, Glenn. We quite often get caught up in the mass, kind of, hysteria of the equity markets, plus all over the papers, all over the press and often neglect what's actually happening in the bond markets. And we've also seen bond markets tracking that volatility but to a lesser extent than what we've seen in equity markets which goes to the critical question and role that fixed income plays in a portfolio.

So, we've seen it, again not unlike equity, play out in the U.S. We've seen U.S. 10-year yields move from 1.6% a couple of years ago up to 3.2% late last year and only recently fall back down towards 2.7%. So, that was a sharp move in bond markets. We haven't seen such a sharp move in the domestic equity – well, so the domestic bond markets but we still have seen that same trend. So, we've seen in the yields spike up a little bit and just in more recent days come back a bit as the market comes down.

But getting to that latter part of your question, what does it mean for the markets going forward in Australia, look, where there is uncertainty, there is going to be volatility. Now, bond markets will display more volatility as the equity markets will, but it will be on a far less scale. So, as we mentioned before, it really gets to the importance of capital preservation in a portfolio and that is the primary function of fixed income. So, it's a really important question. It's one that our clients need to be cognizant of and continually remind themselves of when they are looking at their portfolio.

Freeman: And are there any parts of the credit space that are less or more attractive in this environment?

Likos: Yeah. Look, I think, when you look at markets in general, sectors in general this year, and if there are sectors that are kind of vulnerable in the equity market, the kind of expectation is that they will possibly also be the ones that will be volatile in the credit markets. Now, just kind of top of the head, you think to yourself, well, there's a lot of discussion, concern around the domestic housing property market. And so, we might be talking about concerns with the REIT space in the equity asset class. Similarly, I would suggest there might be perhaps some weakness in the REIT bond space as well.

But it won't be, as I mentioned earlier, the same level of volatility as in the equity markets. We can see wild swings in equities, 5% 10% in a day. Extremely unlikely to see that in the bond markets unless of course there is a liquidity concern or kind of a credit risk concern. So, from our perspective, we think it's important to stay on the investment-grade scale, stay in rated bonds, stay in that kind of BBB upwards in terms of credit rating. I'd also probably be a bit hesitant buying too long dated a bond, although we don't expect interest rates to go up this year or down this year. We kind of expect them to pretty much be flat.

Freeman: This is domestic interest rates?

Likos: Domestic interest rates, yeah. And therefore, we are kind of more sort of preferred sitting on that shorter-term, medium-term kind of duration in the bond space.

Freeman: Another theme that we've heard a lot is about household consumption and this is something Peter Warnes from Morningstar has spoken about at length mainly within the context of the equity markets. But how does that also play – does that play into what you are saying there about the importance of credit and fixed income within this environment?

Likos: Yeah. Look it does. And even go a step further and say to that interest rate expectation of ours, a lot of that is born out of our concern for the fall, the drop in consumer spending, for example. So, what happens as a result of that is, if consumer spending does slow, then your everyday companies, whether it's Woolworths, whether it's JB Hi-Fi that's reliant on this discretionary spend, well, they are going to have to pare back their growth expectations.

And when companies pare back growth expectations, well, that's when you see equity fall. And if it's an unexpected pairing back of expectations, you see rapid, sharp falls. You're not going to see those same percentage falls in fixed income. You might see a fall, but you got to remember the critical concern with fixed income is will I get my money back. Now, you might see some aberrations in price; it might fall to 95%; it might fall thereabouts. But ultimately, assuming and expecting that there's minimal credit risk and you are going to get your money back, that should continue the trend to par and you should get that par investment back.

Freeman: So, you're saying – so, arguably that fixed income is more important in 2019, then it becomes more important, the more protracted, the sell-off in equity markets and the volatility becomes?

Likos: Yeah. I think it's always important. I think it's going to be just more glaringly important this year. Because more investors are probably to suffer paper losses on their investment portfolios as a result of the greater volatility that that markets are seeing, which is driven by a whole range of factors, but ones that Peter Warnes goes into in his weekly almost every week. Therefore, we believe and what we're already in some of these institutional fund flows, money is going to move out of equity and we are already seeing it move into fixed income fund exposures. Because all of a sudden, people are saying, well, you know what, maybe I'm going to pare back my ambitious 10% return targets which we've had for such a long time and being spoiled with, and actually, you know what, maybe I'm happy just to take 3%, 4%, 5%, cover my cost of living and know that I'll have that amount of capital at the end of the year as I had at the beginning.

Freeman: Sure. We'll keep an eye out of your upcoming quarterly report into the credit space as well. But thank you very much for your time today, John.

Likos: Yeah. Always glad to be back. Thanks, Glenn.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Glenn Freeman  is Senior Editor for Morningstar Australia