Thursday, November 25 2010
Bond returns have been strong over the past two years. The investment we suggest clients use has returned 11.03% over the 12 months to the end of October and an annual return of 10.07% over the past two years. This is a strong return from a defensive investment only invested in AA or higher rated government and corporate bonds. When you consider that the expected return from the riskier equity asset classes is somewhere between 10 & 11% per annum a fair question to be asking is why bother with those volatile asset classes and rather stick with bonds?
To provide an answer to this question you need to have an understanding of how bonds work and the underlying risks. Vanguard have published a simple discussion in an article on their website - Evaluating Bond Risk. The article explains that the historically low interest rate environment in the world economy has driven bond prices up and yields down. These prices rises have been reflected in bond returns. As the global economy continues to improve and interest rates move upwards we should start to see a reversal of the recent phenomenon of low yields and high prices. This highlights that there are risks involved with bond investments especially with long term bonds as prices are likely to fall. Bond returns are likely to experience a less prosperous period at some point in the future.
The article highlights why we believe it is important to keep bond investments focused on high quality and lower time to maturity bonds in order for this exposure to provide a slightly better return than cash over the long term but with very much reduced levels of volatility compared to equities. This is exactly how we choose our fixed interest / bond investments for clients. The recent returns have been great but we should expect them to fall back to somewhere about 1 or 2% above the cash rate over the long term.
To get the growth clients need to fight inflation and build wealth there remains a place for a diversified portfolio of equities.
To find out more about our approach please take a look at our Building Portfolios page on the website.