Fureyous

Bonds were not surprisingly the highest performing asset class in 2008. Advisers can expect increased promotion of bonds by BDMs and fund managers and the issuance of new products (eg the new Vanguard Australian Government Bond Index Fund). What is our view?

· Australian Bonds: Neutral, with a likely move to underweight
· International Bonds : Underweight

The headline in the recent Morningstar performance league table was something along the lines of “Australian Bonds best performing asset class since 1992” with a return of 14.95%, but what about 2009?

Last week, Vanguard launched their Australian Government Bond Index fund after the “Commonwealth Bond >10 years Accumulation index“ had an enormous return of 27.72% in 2008. However with government bond yields currently at their lowest for many many years (and therefore their highest price) is this the latest bubble?

At the time of writing (January 27), Australian government bond yields that mature between 1 and 15 years range in yields between 2.54% and 4.16% so if held to maturity then these yields are the highest returns that can be expected. However, what is in favour of the bond investor is that it is possible for bond yields to fall much further. Australian yields are much higher than those overseas where the 10 year US Government bond trades at a yield of 2.64% and in the UK, 3.70% (compared to Australia’s 4.16%). With China’s economic growth slowing rapidly, it is looking increasingly likely that Australia will go into recession and this could well result in lower bond yields and therefore higher prices. Overall, the combination of record high bond prices with an economy under pressure means the outlook for Australian bonds is “Neutral” with an expected next move as “Underweight” … but not quite yet.

Global bond prices, on the other hand, have very little room to increase. US cash rates are effectively at zero, so too is Japan, and Europe isn’t far behind. As already mentioned the longer term yields are also very low. After a solid 2008 annual return for hedged global bonds of around 13.5% (according to the Citigroup World Government Bond Index), the downside risks appear far greater than the upside potential so the outlook for hedged International bonds is “Underweight”.

Bonds typically perform best in a deflationary environment whereby a dollar today is worth less than a dollar tomorrow. Should the outlook for the global economy move towards deflation then it is likely the outlook for bonds will be more positive than the current view.

Just to sort out the differences which by their name alone doesn’t appear to be much…

·         Credit Suisse International Fixed Interest is a global bond fund and has been sold to Aberdeen…its quite a conservative fund that invests in very high rated fixed interest investments…on the other hand…

·         Credit Suisse Global Income is a global credit fund that is regarded as “Alternative Income” with significant allocations to lower rated bonds and has not been sold to Aberdeen, is retained by Credit Suisse.

Massive difference in performance too…International Fixed Interest returned an excellent +12.17% for 2008 whilst Global Income returned an awful –33.31%!!! Strangely, the poor performer is higher rated by research agency Lonsec whilst the other is not…but, personally, I expect their returns for 2009 to reverse so am comfortable with their ratings (which is driven by the Aberdeen purchase).

I received a call from an adviser earlier in the week who wanted my opinion in terms of increasing a client’s allocation to Colonial’s cash account and reducing the allocation to Colonial’s Diversified Fixed Interest fund. For 2008 these 2 funds returned around 6.5% and 0.1% and the adviser’s thoughts were that these returns suggested perhaps the switch was appropriate. Now, whilst we know the past doesn’t equal the future, I believe this tactical switch is not appropriate for other tactical reasons as follows…

·         An earlier post in this blog shows the direction of interest rates and that is clearly down…so increasing allocations to cash should not yield spectacular returns by any stretch of the imagination

·         The reason Colonial’s Diversified Fixed Interest only returned 0.11% wasn’t because of conservative bonds (which had wonderful 2008 returns) but because of credit exposure.

·         Given credit spreads are still quite high whilst conservative interest rates locally and globally are at record lows suggests to me that the return potential in 2009 does not rest with cash or bonds but in credit related securities like corporate bonds…therefore, reducing the allocation to Colonial’s Diversified Fixed Income is reducing the return potential and increasing the allocation to cash is virtually guaranteeing another low return

The above chart is everyone’s latest favourite, the VIX index (otherwise known as the Fear Index). Today it closed at 57, up from 50 at the start of the day, and as can be seen it is creeping back up towards those October and November levels. Given the S&P500 closed down today by more than 5%, its no wonder the VIX is up but the big question is…does this mean there is more pain to come?

So what is the VIX index?…its a mathematical calculation of the implied volatility taken from S&P500 option contracts that are sold on the Chicago Board Options Exchange (CBOE). It is an expectation of the S&P500 market volatility of the next 30 days.

This morning, The Sydney Morning Herald suggested that when the short selling ban is lifted AMP, NAB, QBE and Wesfarmers are stocks that are “most likely to come under pressure”. If this is true, what on earth do hedge funds or short sellers know that the rest of the “long only” funds management industry, stock analysts, and shareholders do not? I’m sure the answer is nothing. These stocks are some of the most researched and widely held stocks by fund managers in this country and if they were seriously overvalued and warranted short selling then existing shareholders would be selling anyway.

Whilst equity markets may not be perfectly efficient, they are mostly efficient most of the time and adjust to news quickly. The biggest price drop amongst Australian stocks in many years occurred whilst the short selling ban was in place. The reality of hedge funds is that on average they are no more skilled than any “long only” fund manager so the likelihood of these stocks being short sold to significantly low prices is ludicrous. Equity prices will only be driven lower by worse than expected news on the company, sector, industry, and/or economy…not short selling alone!

If you want know what the RBA is likely to do next, there is probably no better chart to look at than the yield curve of Australian Government Bonds. With the lowest point being around 2.75% at the 2 year maturity and the 15 year rate barely above 4%, clearly the market believes rates are going to stay much lower than the current 4.25% for a long time.

As for next steps, given a 1 year (which really matures mid September 2009 … just 8 months away) bond yield of just under 3%, the market expects the RBA to lower rates down to 2.75%, possibly lower, sometime over the next three to four months.