Why bonds remain one of the best options for your retirement plan

The Sterling Report

Marian Ross

Saturday, May 31, 2014

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THIS week, Mohamed El-Erian wrote an interesting article on Bloomberg explaining his view on why bond prices keep rising and why investors seem reluctant to give up on the asset class. El-Erian referred to elements of "behavioural finance" to make a few interesting points; the spirit of which I have tried to provide below:

*The "resilience of bond prices" and the sustained rise in value of bond portfolios have made investors less anxious to sell their holdings. (Who doesn't like looking at the large positive number in their investment revaluation reserve?) Investors who rely on past performance to make their investment decisions, are very comfortable entering or even remaining in the bond market because of the asset class's strong performance.

*Institutions such as insurance companies and pension funds are taking the gains they have accumulated in the equity market and now investing in long dated bonds.

El-Erian made sure to state that he was not positing that a movement away from bonds and into equities would never happen. Similarly, as investment managers we can well foresee a portfolio reallocation when the environment changes. However, for the time being, slowing inflation and overall mixed economic data are some of the factors contributing to an advance of bond prices in the USA and Europe. Additionally, there are also fewer issuances of debt by companies and Governments resulting in a lower supply of fixed income instruments. This confluence of factors has resulted in a significant reduction in yield in the bond markets. Some bond portfolios were up as much as 15 per cent in US dollar terms as at March 2014.

It is important to note that the entire fixed income asset class does not become obsolete with tightening monetary policy or rising interest rates. Rather, different types of fixed income assets become attractive. For example, there has been a surge in issuance of fixed income investments with built in options that give investors exposure to the equity markets or minimise their exposure to duration risk. These options increase the value of the fixed income instrument and provide investors with a tool to protect themselves against rising interest and inflation rates. Similarly, a series of "hybrid" investments that combine features of debt and equity have also rose The delayed interest rate hike gives investors time to reallocate their funds (within the fixed income asset class) to assets that are less susceptible to the adverse effects of rising rates and even take advantage of the change in economic policy.

However, as usual, what separates the good investment managers from the mediocre ones is making the right call at the right time. Some investment managers predicted a sudden and steep rise in the yield of 10-year US treasury bonds (UST). They cited the onset of tapering and a potential rise in interest rates as reasons for the decreased allure of bond investing. However, since the announcement of tapering in 2013, the 10-year UST has fluctuated between a high of 3.002 per cent and a low of 2.42 per cent. The massive sell off that was predicted has not materialised -- yet.

In the last two years, there has been a wide variety of Jamaican dollar denominated products that offer local pension funds and investors a hedge to their Jamaican dollar exposure. These products invest in the US and European fixed income markets and provide pensioners with a store of value in a hard currency and developed economy. Many independently managed pension funds and prudent investors took advantage of these products and they have realised returns in excess of 30 per cent in Jamaican dollar terms and over 10 per cent in US dollar terms. They also minimised the "downside risks" in our local economic environment.

Despite the delayed response to the change in US monetary policy, investors and investment managers should take steps to re-arrange their fixed income portfolios and prepare for future changes. Reducing duration risks and looking at different types of structured investments are ways of preparing of your portfolio to generate returns in an environment of rising interest or inflation rates.

Marian Ross is AVP - Business Development at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm, like our page on Facebook and follow us on Twitter. If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm




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