Bonds in the spotlight

Many myths and misconceptions about bonds abound, particularly during periods of rising rates. Here’s why despite current economic conditions, investing in bonds is still essential.

Written by Jean Bauler, Head of Bond Indexing, Asia Pacific

Fixed income markets routinely hum along without much fuss, leaving the share market to capture attention and fire up the hearts and minds of investors. Because unlike the more volatile share market – which saw swings between a -43% return in 2009 to almost 20% in 2019 – returns in the bond markets are typically more modest and more stable, delivering between -3% and 13% since 2009.

But thanks to inflation spikes and the potential for rising interest rates, two topics that are inextricably linked to the fixed income market, bonds are now firmly in the spotlight. And rightly so, with the Bloomberg Australian Government bond index returning negative 9.1% since the start of the year, echoing similar figures seen in other fixed income markets around the world.

As a result, many an investor, especially those invested in balanced or conservative portfolios, may be feeling jittery about the near-term risk of bonds. And given that bond prices fall as rates rise, news of the recent RBA cash rate rise with several more to follow have only served to heighten investor concerns.

Many myths and misconceptions about investing in bonds abound, particularly during periods of rising rates, often coupled with calls for investors to make drastic portfolio changes. But while it is true that bond returns have taken a hit since the start of this year, any suggestion to avoid bonds today may be backward-looking and probably belated.

Rather, investors should take heart that financial markets are forward looking. In the current climate where rates are assumed to rise, today’s prices of short, intermediate and long-term bonds have already factored in such expectations. Indeed, the Australian market has already priced in 10 additional hikes for the remainder of this year, and if that consensus view were to play out, there would be no advantage in shifting to shorter-term bonds or going to cash. Such moves would pay off only if yields were to rise more than expected; it’s also possible that yields will rise less than expected, in which case long-term bonds would do better.

Further, any advice to time the market – typically based on public consensus information that is already priced into the markets – should be taken with a pinch of salt. It is exceptionally difficult to pick the best entry and exit points on the share market, particularly on a short-term basis, and the same holds true for the fixed income market.

The benefits of bonds as a diversifier in an investment portfolio cannot be overstated, especially for those approaching or already in retirement. It is a defensive asset class that cushions a well-diversified investment portfolio – providing ballast should equity markets tumble. Bond investors can also take heart from the silver lining to rising interest rates – the upward trajectory is good for bond investors if their investment horizon is sufficiently long. If the short-term fluctuations in your investment portfolio are keeping you up at night, perhaps consider that your asset allocation is out of sync with your risk appetite and in need of a review.

All this to say, it can be nerve wrecking to stick it out and keep to your financial plan during periods of volatility – even for the most experienced investors. But rather than spend time worrying about unrealised, short-term losses in your portfolio, you are better off channelling your emotions towards staying focused on your longer-term financial goals.

An iteration of this article was first published in the AFR on 10 May 2022.