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The latest Tyndall Investments white paper, “Fixed income: demystifying the myths about bonds”, looks at the critical role played by bonds in investor portfolios and demystifies five major myths about bonds that may cause investors to undervalue their benefits.

The latest Tyndall Investments white paper, “Fixed income: demystifying the myths about bonds”, looks at the critical role played by bonds in investor portfolios and demystifies five major myths about bonds that may cause investors to undervalue their benefits.

The myths* studied by Tyndall are:

1. Shares outperform bonds over the medium and long term
2. Interest rate rises cause negative bond returns
3. Cash is riskless
4. Term deposits are a better investment
5. All fixed income is the same.

(For more detail on of the five myths, see end of the release.)

The paper says that, apart from the intrinsic benefits of a known and relatively high rate of income and a return of capital at a predetermined date, bonds provide investors with a useful diversifier to shares.

“The forces that drive shares down are usually the same ones that push the value of bonds up.

“Fixed income can therefore significantly outperform shares in the short term, but over longer periods of time can also outperform shares as well as cash and term deposits,” the paper says.

The paper was co-authored by Ms Anita Daum and Mr Darren Langer, joint heads of portfolio management for the Tyndall fixed income team.

Ms Daum said that perhaps the most common myth is that shares outperform bonds over the medium and long term, but in fact this isn’t always true.

“Most investors expect shares to always deliver higher returns than bonds but, as an example, for the 10 years leading up to February 2008, bonds just edged out shares in returns.

“This shows that investors are not always rewarded for taking on the higher risk of shares rather than bonds. And if their investment time frame is less than 10 years, the risk of shares underperforming bonds increases.

“During the last 20 calendar years, bonds have outperformed shares in six of those years, or thirty percent of the time, including in both 2008 and 2010,” she said.

Mr Langer added that bonds have continued to produce relatively steady and stable positive returns since the start of the global financial crisis (GFC) while shares still remain below their pre-GFC levels.

“Sharp and significant increases in short-term interest rates will tend to trigger a negative return for bonds. However, since the most recent significant bond market rout in 1994, the Reserve Bank of Australia has changed the way it manages monetary policy, so it is less likely that such sharp rises will happen in the future.

“In addition, the size of any negative return is usually much less than the potential negative returns from shares, and bonds usually recover much more quickly.

“For example, from December 1994 to March 2011 on a rolling 12-month basis, bonds didn’t produce a negative return over a period greater than four months. In contrast, it can take years for shares to recover their losses to regain their previous highs,” Mr Langer said.

In the paper, Tyndall also compares investing in bonds to keeping money in cash, in particular the reinvestment risk associated with holding cash, and looks at why bonds are a better investment than term deposits. It found that over the longer term, bonds have outperformed term deposits, and there is a significant sacrifice of return in investing in term deposits over the longer term.

“Term deposits may have provided some short-term benefits but over the medium to long-term, bonds have performed better. Since 2002, for instance, bonds have clearly outperformed term deposits, even through the GFC.”

Ms Daum added that, just as individual bonds have different characteristics, so do fixed income indices and products.

“There are many options that allow investors to tailor the maturity and credit profile of their fixed income portfolio.

“However diversification for the sake of diversity is not an aim in itself and skill is required when choosing securities. It is why bond investors are likely to be better served by choosing a manager who has the skills to avoid securities that are likely to default,” she said.

The paper further explains that not all fixed income investments are the same, with four main strategies at the disposal of fixed income managers that can add value. These are duration; yield curve; sector allocation; and credit selection.

“Each one of these strategies provides opportunities for the manager to add value, but this requires an effective process, a robust risk framework, and skill,” the paper says.

A summary of the five myths are:

Myth 1 – Shares outperform bonds over the medium and long term.
While it is rare for bonds to outperform shares over a long time period, it has happened. Investors may not be duly rewarded for taking the higher risk of shares, particularly if their time horizon is less than 10 years.

Myth 2 – Interest rate rises cause negative bond returns.
While bonds generally produce relatively steady and positive returns, there have been periods when they have produced negative returns. However, the size of the negative return and the time taken to recover the loss is significantly smaller for bonds than equities.

Myth 3 – Cash is riskless.
While investing in cash can provide investors with greater flexibility, they may be subject to reinvestment risk – that is, the risk of missing out on the capital gain benefit of a fall in interest rates and that proceeds will need to be reinvested at a lower rate.

Myth 4 – Term deposits are a better investment than bonds.
While term deposits can offer greater short-term security and potentially higher returns in the short term, there is a significant sacrifice of return from investing in term deposits over the long run.

Myth 5 – All fixed income is the same.
Individual bonds, market indices and products are not all the same. It is important that investors know exactly what they are investing in and be selective about the risks they want to incorporate into their fixed income portfolio.

An effective process, robust risk framework and a fund manager’s skill are all factors that investors need to consider.

* In Tyndall’s research, bonds are measured by the UBSA Composite Bond All Maturities Index; shares are measured by the S&P ASX 200 Accumulation Index (as at March 2011)

Fixed income: demystifying the myths about bonds” is available from www.tyndall.com.au

Tyndall Investments Australia offers Australian equities and Australian and global fixed interest funds to retail and institutional investors in Australia. It has over A$22 billion in funds under management (as at 28 February 2011). Tyndall Investments is a wholly owned subsidiary of Nikko Asset Management Co., Ltd., one of the largest asset management companies in Japan with approximately A$125 billion in funds under management (as at 28 February 2011).

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19 July 2011