Bonds v equities – it’s all relative

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The UBS Composite Bond Index is designed to measure the performance of the Australian bond market.  The index consists of approximately 300 fixed interest securities issued by the Commonwealth Government, the State Government and semi government authorities, as well as investment grade corporate issuers. This index provides a good representation of the movements in value and interest rates of this asset class, not unlike the ASX 200 index that most investors are familiar with.

Figure 1 above shows the return of the UBS Composite Bond Index versus the ASX 200 Accumulation Index (the index comparison starts in 1989 when the Composite Bond Index began, however Bloomberg data is only available for the graph above from 1992). If you invested $100 in each at the start date (September 1989), you would be marginally in front by investing in the bond index over the equity index.

[Editor’s note – the above analysis does not take into account the beneficial tax impacts of dividend imputation for equities.]

The steady inclining line of the bond index underpins the importance of allocating a portion of your investments to bonds – they act as a cushion to the volatility of your equity investments. This is the reason professional investors – fund managers – always hold allocations to bonds in their portfolios.

Long-term interest rates move higher

Two weeks ago I wrote about how comments from Fed Chairman Ben Bernanke suggesting the easy money of Quantitative Easing wouldn’t last forever had spooked markets and reminded investors of the importance of considering risk. Since then we have continued to see the swap curve (effectively the benchmark rate that banks will lend to each other at) move wider in the later years.

Figure 2 shows the yield on the five-year swap curve having increased by 28 basis points over the last month – an increase that is reflected in the returns on offer for investors targeting bonds with similar maturities.

My view on the best value in the market hasn’t changed; investors just get some extra kicker in their yield. We continue to see the best value in the curve presenting in maturities in the 2018 to 2020 period.

Term deposits remain lower for longer

The term deposit rates on offer for the coming year reflect the banks’ interest rate expectations and show there’s little additional reward for investing for longer terms (see Table 1). In fact, the best major bank rate declines from 4.10% for 90 days to 3.95% for one year. Investors only receive an extra 35bps (0.35%) for a five-year term. The best rate on the table is in the “other banks” category and shows 4.87% but investors need a minimum $500,000 to access this rate.

Bond market in review

Domestically, the RBA left the cash rate unchanged at 2.75% in line with market expectations. Economic data was mixed with residential building approvals falling by 1.1% in May and retail trade growing by 0.1% in May. The May trade balance beat market expectations, with a trade surplus increase ($0.7 billion) in May due to a 3.6% increase in exports.

Fitch has released its half yearly report “Australian Mortgage Delinquency by Postcode – 31 March 2013”. Delinquency rates across Australia have increased to 1.45% from 1.20% at the end of September 2012, but remain below the five-year average of 1.53%. Increased arrears, particularly in low income/high unemployment regions, indicate the RBA’s decision to reduce the cash rate did not positively impact mortgage performance in the six months to March 2013. The market expects at least one further cut to be made this year.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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