The Benefits of Bonds in the Current Environment
1. Diversification
Bonds offer a low to negative correlation with other risk assets and this supports the importance of having bonds as a diversification instrument. Using Blackrock data as at 30 September 2021, the following AUD fixed income indices show a low to negative correlation to risk assets. For this period, the range of correlations for traditional fixed income ranges from 0.52 to -0.25 relative to traditional risk assets and from -0.12 to 1.00 relative to government bonds respectively.
Table 1. Correlation Between Fixed Income and Equities
| Currency | Asset class | Asset | Index | Gov’t bonds correlation | Equities correlation |
|---|---|---|---|---|---|
| AUD | Fixed income | USD EM debt | JP Morgan EMBI Global Diversified Index | 0.35 | 0.33 |
| AUD | Fixed income | Global high yield | Bloomberg Barclays Global High Yield Index | 0.06 | 0.52 |
| AUD | Fixed income | Local currency EM debt | JP Morgan GBI-EM Global Diversified Index | 0.22 | 0.34 |
| AUD | Fixed income | Australian corporate bonds | BofA Merrill Lynch Australia Corporate Index | 0.64 | 0.01 |
| AUD | Fixed income | Australian inflation-linked government bonds | Bloomberg Barclays Australia Government Inflation-Linked Bond Index | 0.47 | -0.02 |
| AUD | Fixed income | Australian government bonds (10+ years) | Bloomberg Barclays Australia Treasury Over 10 Year Index | 0.81 | -0.15 |
| AUD | Fixed income | Australian cash | 3-month cash of Australian government bond quality | 0.00 | 0.00 |
| AUD | Fixed income | Australian government bonds | Bloomberg Barclays Australian Aggregate Treasury Index | 0.78 | -0.14 |
| AUD | Fixed income | Global corporate bonds | Bloomberg Barclays Global Aggregate – Corporates Index | 0.65 | -0.01 |
| AUD | Fixed income | Global aggregate bonds | Bloomberg Barclays Global Aggregate Index | 0.95 | -0.18 |
| AUD | Fixed income | Global government bonds | BBG Barc Global Aggregate Treasury Index | 1.00 | -0.25 |
| AUD | Fixed income | U.S. bank loans | S&P/LSTA Leveraged Loan Index | -0.12 | 0.45 |
| AUD | Fixed income | China government bonds | BBG Barc China Treasury + Policy Bank Total Return Index | 0.12 | 0.23 |
* November 2021, data as at 30 September 2021
2. Efficiency
The low risk profile of bonds allows for efficient returns per unit of risk. The table below shows the return/risk ratio for various fixed income indices and traditional risk assets for the trailing five years (all returns annualised). The return/risk ratio for the Bloomberg Barclays US Aggregate Bond Index is the most efficient allocation across the spectrum. Thus, while potential returns for bonds in the low yielding environment may not seem that appealing, investors should consider an allocation to bonds considering the low risk profile of bonds.
Table 2. Return/Risk for Various Fixed Income Indices and Traditional Risk Assets
| Currency | Asset class | Index | Return | Volatility | Return/Risk |
|---|---|---|---|---|---|
| USD | Equities | S&P500 Index | 15.2% | 15.3% | 0.99 |
| USD | Equities | MSCI EAFE Index | 7.4% | 15.4% | 0.48 |
| USD | Equities | MSCI EM Index | 12.8% | 17.6% | 0.73 |
| USD | Private Equity | iShares Listed Private Equity ETF | 13.2% | 22.3% | 0.59 |
| USD | Hedge Funds | Credit Suisse Hedge Fund | 4.1% | 5.5% | 0.74 |
| USD | Fixed income | Bloomberg Barclays US Aggregate Bond Index | 4.4% | 3.2% | 1.38 |
| USD | Fixed income | Bloomberg Barclays US Treasury Index | 3.8% | 4.0% | 0.95 |
Source: MorningstarDirect. As of 31 December 2020
3. Credit Quality
The average credit rating of bonds outstanding in the Australian corporate bond market is high by international standards. The Bloomberg AusBond Composite 0+ Yr Index has an average rating of AA+ equivalent versus the Bloomberg Global Aggregate Credit Total Return Index (Unhedged USD) of A equivalent respectively.
Those four notches of difference (between AA+ and A equivalent) in credit quality imply a significantly lower average cumulative default rates on Australian bonds versus international bonds.
The global default rate for investment-grade companies is only 0.02% and 2.4% for high-yield corporate bonds in the three years to December 2019 according to data from the S&P Annual Global Corporate Default and Rating Transition Study.
Chart 1. Global Default Rates: Investment Grade vs Speculative Grade
Source: S&P Annual Global Corporate Default and Rating Transition Study
4. Risk Mitigation
Bonds suit investors who are in the retirement or deaccumulation stage in their investment life cycle. Many other traditional risk assets like equities as well as alternative assets like real estate and private credit cannot achieve the same drawdown risk mitigation. For example, having a portfolio that is comprised of 60% equities/40% bonds versus a portfolio of 100% equities can help avoid a situation like the recent COVID-19 sell-off in traditional risk assets.
Consider also that for the first three months of calendar year (CY) 2020 the S&P500 Index fell by an annual equivalent of ~60% compared to the Bloomberg Barclays US Aggregate Bond Index – which increased by an annual equivalent of ~13%. Thus, wholesale investors would have netted a handsome return during what was a very tumultuous period had they managed their equities/bond exposure well.
5. Income Generation
Bonds can still generate good returns. Over the last ten years, the Bloomberg Barclays US Aggregate Bond Index has generated a cumulative total return of 34.66%, with most of this comprised from the income/coupon component (30.07%).
Wholesale investors like income/coupon generation and bonds continue to provide good income/coupon prospects regardless of the low yielding environment and associated equity dividend yields.
Chart 2. Bloomberg Barclays US Aggregate Bond Index Total Return
Source: Bloomberg Barclays US Aggregate Bond Index performance over time
About Matthew Macreadie
Matthew’s current responsibilities include providing credit commentary/views on the bond market and specific issuers, with the aim of aiding investors to make better risk-return decisions.
Prior to joining Income Asset Management, Matthew spent eight years working as a Credit Portfolio Manager at Aberdeen Standard, where he was responsible for the credit portfolio construction and security selection across a wide range of financial and non-financial sectors.
Matthew began his career at KPMG working in Auditing and Assurance within the consumer and industrials group. Matthew holds a Masters of Applied Finance from Macquarie University and a Bachelor of Commerce from UNSW.
