The first point we should make in the case for bonds is, despite the long term outperformance of shares, the average professionally managed fund in NZ has, for the last 30 years or so, averaged a 40 per cent weighting in bonds and there is no sign of them lightening up. Furthermore professional managers overseas, according to the London Financial Times, are today increasing their weighting to bonds irrespective of the low yields.
Interest rates overseas are very low but perhaps the low yields simply reflect a dire economic environment with low growth and low inflation for the next 10 years. This would not be good news for shares, indeed Andrew Smithers at London economic consulting group Smithers and Co reckons that US shares are overvalued on the basis of their longer term historic valuation measures and, contrary to analysts' expectations, he sees profits and dividends falling over the medium term as governments and individuals deleverage.
Bonds have other attractions too: a sustained period of weakness in sharemarkets can sorely test an investor's conviction, particularly if all their money is invested in shares. Fortunately high quality long term bonds frequently go up in value when the stockmarket plunges. Bonds are thus the best insurance policy there is for the really bad times. This point should not be underestimated - too many people with 100 per cent invested in shares panic when the going gets tough and sell.
The lesson from the past is clear: different asset classes perform differently in varying economic environments. When monetary conditions are inflationary shares do better than bonds because companies can raise prices whilst bond coupons are fixed. Conversely in a period of deflation, i.e. falling prices, high quality bonds are clear winners as most have fixed coupons.
Just about everyone says that bonds are overvalued but when they say that they frequently mean overseas government bonds. Whilst the yields on the government bonds of most of the larger developed countries are below inflation this is not the case in NZ where we can today purchase high quality bonds issued by double AA rated institutions with yields as high as 4.8 per cent pa.
This is well ahead of current inflation and, if the yields on US bonds are any indication, likely to be even further ahead of future inflation. Whilst 4.8 per cent doesn't sound compelling at present it might look rather good if short term interest rates fall from their current levels. There are some indications that this is possible:
• Firstly NZ's interest rates are much higher than those of other western economies. According to the Reserve Bank this is because we don't save enough. However there may be some convergence in interest rates as has happened in the past as overseas investors are more comfortable with foreign exchange risk and are tempted by the big margin. In the past NZ inflation has been higher than that of big economies like the US but those days appear to be over thereby making our bond yields relatively attractive.
• Secondly the current economic environment looks eerily similar to that which prevailed prior to the 1930s depression and Kenneth Rogoff who authored a study of 400 years of financial crises has labelled the current situation as being the Second Great Contraction. He reckons that the best outcome that we can hope for given the deleveraging that needs to take place is 10 years of below trend growth and inflation.
How is this significant? Well in the 15 years after the great depression US bank interest rates averaged about 0.1 per cent pa. Today if you invest $200,000 at the 4.0 per cent rate for six months that's $8,000 pa in income. At 0.1 per cent $200,000 earns just $200 pa. If this sounds impossible consider the fact that it is a reality today for most of the western world's retired investors.
• Thirdly there is an economic theory called the term structure of interest rates and this simply says that longer term interest rates are a combination of the forecast short term interest rates over the period. So if we look at longer term interest rates we can get a view as to what the market is thinking short term interest rates will be but we also need to remember that longer term rates are usually higher than short term rates to account for risk. In NZ ten year government bond yields are approximately equal to six month term deposit rates. If we adjust for the term premium long rates may well be signalling much lower short rates.
In previous articles we have noted independent expert forecasts for long term world stockmarket returns of 6.0 per cent. That 6.0 per cent is risky but the 4.8 per cent for long bonds, whilst not risk free, is much more certain. The other big attraction of bonds relates to the degree of income that they deliver and the certainty of that income.
Compare that with the average yield on the world stockmarket today - about 2.5 per cent pre-fees, pre-tax. That's the good news. Now for the bad news - management fees and other fees average about 1.5 per cent and tax, thanks to Michael Cullen's unfair "fair dividend tax" is 1.65 per cent no matter what the actual after fee income of the fund. What all this means is that if you invest $200,000 in your favourite international equity fund the after tax income is likely to be negative. Looked at in that light 4.8 per cent with no management fees and little risk doesn't look too bad.
Things are looking a bit dodgy as far as global stockmarkets are concerned with major markets falling sharply and bond yields plunging. Note this is the exact opposite of what many people were saying was going to happen at the beginning of the year. There is a very real risk that a huge wave of deflation is going to crash over the world, possibly originating in China. The best way to cope with this risk is probably by buying long dated, high quality bonds.
Now you might say why should I commit my money to a 10 year investment at only 4.5 per cent when the bank will give me 4.0 per cent for 1 year? The answer is 4.0 per cent for 1 year is nice but if you intend living for longer than that and you go to reinvest the funds in a year's time at 3.0 per cent you might not be happy or, as the FMA like us to say, your investment objectives might not be fulfilled.
Whether long term bonds are a good buy at 4.8 per cent or not is open to debate and if inflation takes off they won't perform well but the bottom line is that the average pension fund has 30 per cent of its money in long dated bonds, long dated bonds have a good chance of going up when the stockmarket goes down and 4.8 per cent looks quite a bit better than 2.2 per cent in the US. If things do get real bad we may see a lot of money chasing these relatively high NZ yields.
Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request.
