I initially wrote this article exclusively for subscribers to the NZ Wealth & Risk newsletter. However, after reading a recent article – "KiwiSaver conservative fund losses shock investors" – I thought I'd share this as a normal blog article.
Bonds have been performing TERRIBLY lately.
As I type this [in mid-May], the 1 year return for Simplicity's NZ Bond fund have a 1-year return of -9.78% (after fees and before tax). 12-month returns for SuperLife funds with the word "Bonds" in their name range from -2.98% and -5.36%. Funds with "bond" in their name on the InvestNow platform range from -3.58% to -7.83%. These returns are even worse in the context of inflation over the same time frame of around 7%.
Yet I still often refer to bonds as DEFENSIVE assets, and consider them to be qualitatively different to more growth-oriented investments such as shares. In the context of the past 12 months, you might wonder why?!!
A few things are worth keeping in mind:
- Over a long enough timeframe, almost every asset class is going to perform poorly relative to other asset classes in some years. It is what it is. Mercer's "periodic table" of investment returns illustrates this point well.
- A corollary: it's rare for the worst-performing asset class to continue to be the worst-performing asset class year after year. Regression to the mean is pretty amazing.
- Bond prices – and, by extension, the returns they generate – are strongly influenced by interest rates. However, this isn't just interest rates as they stand, but expectations relating to interest rates. If interest rates change as expected, these expectations will have already been baked into bond prices, which means that there won't be significant swings. If interest rates expectations change significantly, however, then bond prices (and returns) are impacted. If interest rates fall more quickly than expected, existing bonds (offering higher yields) become more attractive relative to newer bonds and tend to increase in value. If interest rates increase more quickly than expected – which is what has been happening, in large part because inflation has been higher than expected – then they will decrease. The price of bonds have to adjust significantly to factor in changed expectations.
- These changes in bond values are significant. But the magnitude of these reductions are not the same as what can happen when shares drop in value. Decreases of -2.98% to -9.78% aren't great, but they are better than decreases of -30% or worse, which can happen in share markets (for example, in the course of a single month in March 2020).
- There are likely to be limits to just how far central banks can increase interest rates over the short-term, which is arguably a limit on how far bonds can fall. Think of all of the households and businesses that owe money to lenders and the second-order economic effects that would follow if interest rates increased dramatically. I think it's unlikely that a central bank will be willing to run the risk of unintended consequences. (This is the closest I am prepared to go in terms of making anything resembling a prediction. I could be wrong!)
- At a fundamental level, your capital tends to be more secure when it is in bonds compared to shares. Depending on how you're invested in bonds, it's likely that the majority of your bonds are issued by Governments. Governments can tax more or "print more money" in order to pay their debts. If they can't repay their debts, you might have bigger concerns than negative returns on bonds. Even with corporate bonds, even if a company became insolvent, as a bond holder you would have priority in terms of being repaid compared to any share holder. So you might lose some capital in the sense that over some time frames the value of your investment might reduce. But the likelihood of losing it all is much lower.
Ultimately, it's another good reminder of the value of diversification. Every asset class has good and bad years. Even more defensive assets like bonds.
As always – I urge people not to make changes to their investment strategy based on what is happening, or has recently happened, in the market. These ups and downs are inevitable. The important thing is to make sure that you're invested in a way that's appropriate for you – based on your needs, circumstances, and objectives.
A couple of comments about the "KiwiSaver conservative fund losses shock investors" article:
- It quotes "businessman" and "entrepreneur" John Bolton as being "shocked at how far the value of the conservative KiwiSaver fund he is invested in has fallen". It conveniently overlooks that Bolton's business is Squirrel, which offers term investments and a monthly income fund. Conflict, much?
- A quote: "KiwiSaver fund manager Paul Brownsey from Pathfinder said conservative fund managers should have seen this coming, and their investors picked conservative funds to avoid large losses. / 'You didn’t need to be a genius to say two to three years ago that investing in bonds was going to be a bad outcome,' he said. / Pathfinder sold out of longer-dated bonds in its conservative fund, holding more short-dated term deposits, which has meant its conservative fund suffered smaller losses than its rivals. / “It was one of the easiest decisions we have made. I’m not going to say, 'We’re amazing fund managers because we made that decision.' Everyone should have made that decision,” he said." Talk about chutzpah. If everyone had thought this, bond prices would have adjusted at the time. Personally, I recall two or three years ago when people were concerned that interest rates would fall further. In some counterfactual universe, events have taken place resulting in interest rates falling rather than increasing, and there will be some other investment manager talking about how "you didn't need to be a genius" to invest the way they did, and Brownsey coming up with some reasonable-sounding explanation for why his fund didn't perform as well as others. To quote Bolton: "hindsight's a wonderful thing".