The value proposition of bond investments will become evident as the global economy emerges from the pandemic, IAM’s Matthew Macreadie says.

As 2021 draws to a close, global stock markets remain buoyant but uncertain (for now) – and many analysts agree that just gives the market outlook further to fall in 2022.

Monetary policy is set to tighten as central banks look to unwind emergency stimulus measures, while concerns around the impact of COVID-19 variants continue to linger.

In such an environment, the merits of a diversified asset portfolio are often most appreciated – where stable income investment can offset volatility in risk assets.

Many Australian investors still lean towards the equity market to achieve income returns through dividends.

But in recent client research, Matthew Macreadie – Director of Credit Strategy at Income Asset Management (ASX:INY) – highlights the five key attributes of bond investing, for what is now one of the fastest growing sectors in Australian capital markets.

Efficiency

As the investing environment grows more complex, an important gauge for investors to assess is the amount of return they can generate for a given level of risk they are willing to accept.

If post-COVID market trends show anything, it’s that equities are prone to wild swings (both up and down) in response to unexpected risk events.

But heading into 2022, “bonds are very much back on the agenda,” Macreadie says. “And one of the main reasons why is that from an efficiency or risk-return standpoint, bonds offer a strong return for the volatility you’re taking on.”

To illustrate, Macreadie compiles data to compare the return/risk ratio for a number of global indices across bonds and equities.

Calculated as a function of returns and volatility, the ratio gauges which asset classes can offer above-average returns with less reliance on the wild price swings.

Across seven indices comprising equities, hedge funds, private equity and fixed income, a fixed income play – the Bloomberg Barclays US Aggregate Bond Index – came out on top with a return/risk ratio of 1.38.

Thus, while bonds may not always be in favour in a low-yield environment, the argument for bond investment grows stronger given their capacity to generate returns above the risk-free rate for a lower level of risk, Macreadie says.

Credit quality

Another factor more unique to the Australian market is the level of credit quality investors can get exposure to through the domestic corporate bond market.

In fact, the Bloomberg AusBond Composite 0+ Yr Index has an average rating of AA+ – four notches higher than the A rating for the Bloomberg Global Aggregate Credit Total Return Index (Unhedged USD).

“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,” Macreadie says.

The global default rate for investment-grade companies is only 0.02% and 2.4% for high-yield corporate bonds.

Factoring in the additional strength of Australian companies, the opportunity is there to structure portfolios with a mix of IG and high-yield debt to generate strong returns with a low level of risk.

Income generation

Staying on the subject of returns, another point worth highlighting is that bonds can still generate strong returns – particularly when factoring in the income component of the asset.

For example, over the last ten years the Bloomberg Barclays US Aggregate Bond Index has generated a cumulative total return of 34.66% – and most of that was returned to investors through the income/coupon component (30.07%).

“In this low-yield environment we’ve seen a lot of larger ASX companies reduce their dividend payments,” Macreadie says.

“And you can contrast that against fixed income which is based on that steady coupon payment. So as an investment narrative it’s really starting to compete now with those traditional dividend-paying stocks that investors like.”

Diversification

Portfolio diversification is a common concept, but Macreadie flags multiple data points which show how bond investments have a low (or sometimes negative) correlation with other risk assets.

Using data from asset investment giant Blackrock to September 30 – extracted from 13 different fixed income assets across Australian and global markets – Macreadie demonstrates how the price action for corporate and government bonds differs to equities.

Through that divergence, Macreadie illustrates how the low correlation between equities and bonds makes fixed income a simple and effective way to build diversified portfolio protection.

Managing risk

The diversification angle ties in with Macreadie’s last point – risk mitigation – which goes back to one of the core value-adds fixed income can provide as the investing environment grows more complex in 2022.

As an example, he cites the first three months of 2020, when global stocks crashed and the S&P500 slumped by an annualised equivalent of ~60%.

Over the same time frame, the Bloomberg Barclays US Aggregate Bond Index rose by around 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,” Macreadie notes.

And for many Australian investors – particularly the large cohort moving towards retirement age – that will remain a prevalent theme in the years ahead.

Speaking to Stockhead, he says many IAM clients are at the stage where they want certainty over their capital. “Investing across the spectrum – from government debt to IG corporate debt to high-yield bonds in Australia – can provide strong returns with a more comfortable risk profile.

There’s a bit of uncertainty at this point in time, and one of the challenges that poses is that investors need to think about portfolio allocation decisions.”

“For example, we saw recently that a small adjustment to monetary policy by the US Federal Reserve had a big impact on risk assets, which are sensitive to any movement,” Macreadie adds.

“So leading into 2022 you want to be prepared and have a portfolio structure that’s not too overweight equities.”

This article was developed in collaboration with Income Asset Management, a Stockhead advertiser at the time of publishing.

This article does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.