The elegantly simple way to protect your capital in this asset class

Let's not sugar coat it, fixed income has been through the wars.  It's gotten so bad that some pundits have even dismissed the traditional 60/40 portfolio as being dead in the water. 

So what's going on? 

In this week's episode of The Rules of Investing, I asked Andrew Canobi, director of Australia Fixed Income at Franklin Templeton, whether bonds are still worthy of a place in investors' portfolios given the carnage the sector has seen recently. 

Andrew made a great case, and I summarise it below. Namely, you'll find out where he sees the best value in fixed income, some markets that have been overlooked by Aussie investors, and the one bond he'd put in the drawer for five years.  

What happened to fixed income?  

In the last year the yield on the US 10 year Treasury has increased about 127%. 

If that were the increase in the dividend your shares paid you, you'd just about feint with happiness. 

But with bonds it's not so simple. If the yield on treasuries goes up (as they have to in order to compete with changes to the risk-free rate), then the value of the note itself goes down because those two are inversely correlated. Imagine a pie - either a bigger piece goes to yield or a bigger piece to the tradable value of the bond. When the slice of one is bigger, the slice of the other has to shrink. 

If you're just getting into the market now, higher yields are great. You're getting a bond for cheap that's paying out a lot of yield. It's not so great if you already own bonds and are watching their tradable value plummet. 

The 60/40 portfolio of equities to bonds, meanwhile, has come under fire because the value of bonds have gone in the same direction as equities. That's a problem, because the 60/40 portfolio works because the value of the two asset classes normally don't move as one. 

It's also easy to forget that if you hold these bonds until they reach maturity - so, holding a 10 year note for 10 years - then you haven't lost out on anything. 

"That is one of the elegantly simple things about this asset class," says Canobi. 

"If you buy a bond that's got a coupon of 4% and it's trading at 95 cents in the dollar; if you have that coupon coming in you're gonna get 100 cents back versus the 95 cents you paid." 

Where to look

You might think that the best value assets are the assets that have been sold off the most. But it's not that simple. 

"One way to look is the place that has underperformed the most, and is that the best place to look? And the answer to that is yes and no."

It's not all about mean reversion. It takes a more nuanced approach to find value.

Some of the larger sources of underperformance have been in very long duration bonds, so the longer the sensitivity to interest rates the more they've declined in value. 

As we move through the tightening period, those bonds will perform again.

"We will get to the point where long duration government securities are of interest."

Yet that dynamic can't be extrapolated to the whole of fixed income. An asset won't necessarily recover simply because it's been under pressure already. 

"If recession risks are higher and more meaningful than they have been - for example high risk, high yielding bonds - may be in for a more challenging period, particularly if there's a recession environment in the US."

It's between those two ends of the spectrum where things get really interesting. 

"Your high quality corporate bonds where the underlying default risk is very low indeed but they've underperformed as yields have moved have moved higher and spreads have moved wider - they look very compelling."

"Those sort of bonds will perform very well once we realise that central banks won't choke off the economy and they say 'yes we've done enough' and start to ease back."

Left field opportunities

It's easy to mistake the fixed income world for the US 3, 5 and 10 year Treasuries, the the Australian equivalents. But it's much broader than that.

"For example, we would look to some of the opportunities that are in high-quality parts of the Asia-Pacific, by which I mean counties like Taiwan and South Korea, which are very strong economies in their own right and offer some interesting opportunities both in terms of bonds in Australian dollars and bonds in their local currencies as well." 

A bond for the apocalypse

At the end of the interview I asked Andrew to give us the bond he would choose to own if markets were to close for five years.

"Right here and now I would be more than happy to own bonds of 5-10 years in maturity, not necessarily government but fairly high quality, A and above, and yields that are well into the 5% range if not 6%."

"So I'd be happy to lock that in the bottom drawer and just go away."