Reuter's Poll for tomorrow's RBA Meeting

Reuters Consensus / Forecasts

Economist  -  RBA Rate ( % )       
AMP -  4.00     
ANZ  -  4.00     
Barclays  -  4.00     
Citi  -  3.75     
CBA  -  4.00     
Deutsche  -  3.75     
4Cast  -  4.00     
GSJBW  -  4.00     
ICAP  -  4.00     
JP Morgan  -  3.75     
Macquarie  -  4.00     
NAB  -  3.75      
Nomura  -  3.75     
RBS  -  4.00     
St George  -  3.75     
TDSec  -  4.00     
UBS  -  4.00     
Westpac  -  4.00     
----------    -----     
Low  -  3.75     
High  -  4.00     
Average  -  4.00     
Median  -  4.00     
----------    -----     
        

RBA Rate Rise tomorrow? Odds on

Australian Government Bond Yields - 29 Jan 2010

Source: Bloomberg

The RBA Cash rate is currently at 3.75% and with government backed 30 day bank bills at 4.12% and the recent tender of 23 March 2010 Treasury Notes fetching a yield of ~3.96% the financial markets are pretty much expecting a 25bps increase.

Whilst the sharemarkets have had the jitters whereby the ASX200 has dropped in excess of 6% this year, it is only government bond with a maturity greater than 1 year whose yields have dropped. The shorter term rates haven't dropped much at all as the market continue to believe that 2010 will be a year of rising RBA rates.

As for the chart above...it doesn't really reflect too much of what I've said and actually contradicts the 3 month rates I quoted earlier...my only comment is...what's going on with Bloomberg such that it quotes 3 month Treasury Notes at 3.75%??? Might be best to double check rates from different sources before accepting them.

The return of lifetime annuities!??!

I just read that the Henry Review is likely to suggest that superannuation can be exchanged for guaranteed lifetime income like lifetime annuities. Strangely, it can be done already by purchasing a lifetime annuity with superannuation money. The problem with the current situation is that there are no lifetime annuities left on the market....Comminsure and not much else.

Hopefully this initiative re-opens competition for this outstanding product, except, instead of the current situation, hopefully the new products are priced appropriately. Yields for lifetime and long term anunities have a long way to go to be attractive.

Interest Rates...relatively stable but a minor dip at the long end

Source: Reserve Bank of Australia

The government bond yield curve certainly expects another 50bps in RBA hikes this year with bonds yielding in the second half of this year trading around 4.3% to 4.4%. But since the start  of the year the yields in longer term bonds have declined a little...this indicates a slight drop in confidence of the Australian economy this year.

As has been widely published, the Australian economy has performed relatively well compared to other developed nations around the world and this is largely thanks to the strong links of the Asian developing economies and their continued hunger for our commodities. With China starting to tighten its credit belt a little there is no cause for alarm, but complacency is not appropriate.

In a week or two, the half yearly reporting season begins and after a few months of relative lack of volatility, I'm sure reporting season may well change that. With US, Japan, and much of Europe in a little economic disarray, the risks still exist, so it should be another interesting year for investors.

Current thoughts on some investing risks and themes

We have seen numerous investment trends come and sometimes go over the last X number of years whether it be technology, commerical property, Buffettology, CDOs, high yield, hedge funds, mortgage funds, etc, but at the end of the day a balance of the key investment risks wins through....i.e. the risks relating to equity, liquidity, interest rates, credit, currency, and inflation.

These are my current thoughts on these risks and some investment themes...

• Liquidity Risk - forgotten for many years (particularly by the MTAA Super fund, and mortgage investors...remember Estate Mortgage???) but it still exists...forget chasing returns and having liquidity at the same time!!! Know what liquidity you need and hold CASH...not the so-called liquid Asian High Yield securities Basis Capital used for liquidity or even Enhanced Cash funds...CASH in a bank or pure Cash Management Trust that get's it returns from 11am, government securities, and bank bills.
• Equity Risk...guess what? equity risk doesn't just turn up in...equities! It can also be found in corporate bonds, hybrids, hedge funds, property securities, and many others...it is essential to understand the true equity risk a portfolio has and don't push some of that risk into the more conservative asset classes like fixed interest. Equity risk can be scary, is required for growth, and shouldn't substitute for anything else...like...an inflation hedge!...investing in equities is often a poor hedge to inflation as the 1970s showed...high inflation is not good for equity performance at all
• Interest Rate Risk...too many have ignored this one...but it can work in your favour in a crisis and can provide some portfolio stability...stockbrokers should try them some day...the whole "everything correlates to one in a crisis" is absolute rubbish...during the global financial crisis, those who diversified their portfolio with pure interest rate risk (i.e. little to no credit risk) from boring government bonds or conservative bond funds received double digit returns from this risk. During a crisis, investors run to quality and boring government bonds are just that...why don't retail investors want to invest in quality???
• Credit risk...in times of crisis this is highly correlated with equty risk...as a result when building portfolios ensure your credit securities do not result in overweighting the exposure to equity risks. However, always keep in mind that credit securities have a negatively skewed return distribution...limited upside with massive downside...so why not just invest in equities instead and leave the fixed interest to boring governemnt bonds???
• Currency risks...what's the Australian dollar going to do? Answer...absolutely no idea. So what to do? Being unhedged was favourable during the GFC as Yen carry trades returned to Japan and the flight to safety went to the US (yep....good ol' Australian currency wasn't considered that safe!). So perhaps unhedged is the go...however, the reverse was true in the recovery...market timing is very very difficult so if you don't know, and I don't, perhaps 50% hedged, and 50% unhedged is the go for global share allocations. Its difficult to invest in international bonds without being hedged to the Australian dollar...I guess if you want ot investin bonds for their safety and income then currency risk removes the safety aspect and perhapd hedged is best.
• Inflation risks...this is my favourite...bonds are best during deflation but the only investment that (hopefully) guarantees strong performance during high inflation is INFLATION LINKED BONDS!!! Governments around the world, including Australia, are issuing more...woohoo!...let's get on board and reduce inflation risk from our portfolios. Life companies issue inflation linked annuities also...let's look at them as well.
• Commodities can also can be a good inflation hedge also but they certainly carry a few other risks but are worthy considerations as they provide diversification with other asset classes. The only thing with commodities is...they mostly supply and demand driven!...there's not really much added value there, so...good luck with picking supply and demand!!!
• Hedge Funds...these guys carry equity risk and/or credit risk...when markets crash...SO DO Hedge funds...the marketing myth of positive returns in any market has been exposed by the GFC and there's two other things...its very very difficult to get your money out and their fees are so big that they have to take on significant risk to get the return...but at the end of the day if you don't know how a fund invests you don't know the risks so...don't invest in hedge funds!
• Emerging Markets...all the rage because of their economic growth...guess what...there is no evidence that shows high returns from countries displaying high economic growth. If Emerging markets aren't in a bubble today...they probably will be tomorrow...so proceed with caution. 
• Mortgage funds...they're gone for a long time
• Australian economy...had an amazing run and is the leading economy in the developed world but keep this in mind...we're basically a hole in the ground and reliant upon commodities. If the emerging economies falter and decide to stop buying our commodities then look out Australia...things may not be so rosy...just keep it in mind...and stop being so complacent about the Australian economy...I know you are so stop it!
• Property...I think I need a new Post for this one! Stay tuned

Common Sense view on Diversification

On December 30, Robert Jaeger wrote an excellent piece on diversification for the Financial Times (article can be found here) that palces a bit of common sense around portfolio construction as it probably should be. As he mentions...

In the good old days, asset allocation revolved around three main asset classes: stocks, for long term growth; bonds, for income and safety; and cash, for liquidity

 ...unfortunately recent years saw this simple asset allocation rule forgotten. He goes on to say...

cash and plain-vanilla bonds were disdained as “drags on performance”. The equity portfolio evolved to include everything from developed to frontier markets. The bond portfolio evolved to include an alphabet soup of complex products that investors didn’t fully understand. And the new category of “alternative assets” (private equity, hedge funds, timber, et al), many of which are illiquid, seemed to offer a way to enhance diversification without giving up returns.

As we all should know by now (although many are still in denial), these so-called diversifiers failed to diversify during the global financial crisis and we ended up holding portfolios that are illiquid (motrgage trusts, fund of hedge funds, and hybrid property funds) and we have dissatisfied clients.

Now I do believe that investment simplicity reined supreme in 2009  and I hope it continues into 2010. Happy New Year to all!

The last 12 months....Australian Government Bond Yields

Certainly an interesting 12 months has transpired in financial markets. The above chart shows the movement in the AUstralian Government Bond yield curve and this time last year the sever downward slope indicated the market was expecting the Reserve Bank to drop interest rates to below 3% during 2009. Clearly that didn't happen but there was a rapid decline down to 3% which was maintained until the last few months.

The yield curve was incredibly steep at 22 Jun 09 indicating an expected strong economic bounceback, however over the last six months the longer term yields have dropped suggesting the economic outlook has subdued a little. What we are left with is still a strong upward looking curve which is a good sign for economic prospects and the market appears to expect continued interest rate rises by the Reserve Bank. However, with a one year government bond yield of approximately 4.25% the expectations of the level of interest rate increases appears to have diminished a little so there's no guarantee of a rate rise in February but a good chance of a 25bps increase in March or April.

A Simple 2009 Review and Outlook piece for clients

The year 2009 has turned out to be a significant turnaround year for the global economy and sharemarkets. At the start of the year, the word depression was mentioned often as many economists, investment professionals and politicians thought entering the world’s second great depression was a potential reality. Thankfully, around March 2009, “green shoots” of the global economy started to appear and whilst they haven’t blossomed into anything too beautiful, we have at least witnessed the emergence of many other “green shoots” that have improved conditions in credit markets, share markets, and in the US some positive signs in their housing market.

Sharemarkets bounce...
For investors in sharemarkets, the year 2008 was one they would rather forget and this continued into the first quarter of 2009 where the S&P/ASX200 index bottomed at the start of March. This was the lowest level for the sharemarket since 2003 but despite a lot of paper talk of the market potentially going lower, as is often the case, when the news out of the sharemarket is at its worst prices start to rise. Although the news continued to be bad it wasn’t as bad as expected and between March and October the S&P/ASX200 increased by almost 60%...an astonishing rebound.

The same was true for global shares despite the US, Japan, and Europe’s economic woes that continue today. For the global share investor, returns were also strong double digits. Unfortunately, for the unhedged investor, which is most of us, the strength of the Australian dollar reduced investors global sharemarket gains and many may well see negative performance for the 2009 calendar year.

Bonds subdued...
The economic “green shoots” that contributed to the increase in sharemarkets from March of this year also contributed to increases in interest rates. Unfortunately for the bond investor, an increase in interest rates results in the decline in the value of bonds. For the local bond investor the strength of the Australian economy resulted in some of the strongest interest rate rises in the world and overall returns for Australian bond investors may well be flat. Global bond investors have fared a little better as the overseas economies have struggled significantly more than in Australia and interest rate movement has been minimal to negative. As a result global bond investors may see annual returns between five and ten percent.

Economic Landscape...
The Australian economy has certainly fared very well compared to the US, Europe, and Japan and this is largely due to three main factors:

1. Strength of our banking system which is significantly more conservative than some of the largest banks in the world
2. Strength in our commodity export sector and geographci position close to Asia. This has provided the ability to leverage from the significant growth in China
3. Strength of our government’s balance sheet who in the good times had budget surpluses allowing these savings to be used for the tough times that turned out to be the global financial crisis

Looking forward it is near impossible to know how investment markets will perform but indications are that overall the global economy will be slow as global households continue to reduce debt and high levels of unemployment (which are expected to still rise) provide a drag on consumer spending. Whilst the global economy is improving there remain significant risks as evidenced by the default in its debt payments by Dubai World. Credit markets are far from normal and this is a strong indication that full recovery is a long way off yet.

In Australia, markets have priced in further increases in interest rates by the Reserve Bank with another 0.5% of rises expected by March or April 2010. Rising interest rates is a sign of strong economic conditions so with a bit of luck if there are no further economic shocks there is a stronger sharemarket into the first half of 2010. Given the volatility of sharemarkets this is far from a sure thing but on the positive side, we are coming from the worst global economic conditions since the Great Depression and we are still a long way off our sharemarket highs which were reached in November 2007.

Dubai World Default

Early signs in the US are that the Dubai World default may not really mean too much. Sure US Stocks fell by more than 1%...which isn't too uncommon nowadays...but conversely, US Bond Yields are up suggesting there isn't too much "rush to quality". Time will tell but I'd suggest this is quite a tame reaction.

Nouriel Roubini, famed GFC forecaster, apparently believes this may be the first of more sovereign defults...if so, then that's a different kettle of fish. But at this stage...the US markets aren't convinced.

Krugman says US Fed's Cash Rate ideally should be minus 6.7%

My favourite Nobel Prize Winning economist's article can be found here…This is quite an astounding conclusion but not too far fetched given the evidence. What really concerns me is that whilst the US Cash Rate ideally should be much lower, our Reserve Bank and (judging by the Yield Curve) our markets envisage significant cash rate hikes over the next 12 months….mmm…do you think we Australians are being just a little optimistic about our growth potential or expectations given the clearly disastrous economy of the US (& Japan,  UK, Euro zone etc)?

Relating the Risks of Bonds to Recent Times

If you are interested in an educational article on the main risks a bond investor faces and how those risks have played out over the past year or two, please visit this link.

Bond Fund Correlations

The above chart shows the 6 month daily correlation between Hedged Global Shares and four Australian bond funds...

• Tyndall Australian Bond
• UBS International Bond
• Macquarie Diversified Fixed Interest
• Principal Global Strategic Income Fund

Each fund is different. Tyndall is invested in high grade Australian bonds, UBS International in high grade global bonds, Macquarie is 60% Australian bonds, 40% global and also takes on some investment grade credit risks, and Principal's fund invests in high yielding securities including hybrids, asset backed securities, junk bonds, as well as some conservative bonds. All global exposures are hedged to Australian dollars.

What this chart demonstrates is the increasing correlation between Principal and hedged international shares from mid 2007, the start of the credit crunch. Basically, diversification benefits did not really exist for the high yielding investment.

However for the other funds, which had conservative bonds as a high proportion, their low correlation with hedge international shares shows their diverisifcation benefits in tact.

So a simple conclusion is...whilst high yielding investment may giove you the opportunity for higher returns, don't think they will provide diversification benefits if sharemarkets tank. With a weak outlook for shares, so too is the outlook for companies to pay their debt so the price of low-grade credit can fall significantly also. A final point, which is often overlooked...bonds have limited upside...at maturity the most you will ever receive is the face value...that's it.

World Government Bonds perform best over last 5 years

The above table shows the returns for various subclasses of fixed interest from the perspective of the Australian investor (i.e. in Austrlaian dollars) through to the end of June 2009. As can be seen, the World Government Bond index hedged to Australian dollars has been the winner over the last 3 and 5 years. High Yield, as expected given the widening of credit spreads over the last 2 years, comes in last.

Disappointingly, the Morningstar index of bond fund managers fall quite short versus their respecitve indices. For example, Morningstar Australian Bond managers perform significanlty worse than the UBS Composite index and the Morningstar Global Bond managers perform well below the BarCap Global Aggregate index.

Yield Curve looking Good...is it too good?

As the above chart shows, the Australian government yield curve has been steepening ever since the end of last year. This yield curve is a good indicator of the future strength of the AUstralian economy. As it shows, during June of 2008 the curve was negative (i.e. sloping downwards) and worst case scenario, is that a negative yield curve signals potential recession as there is no premium for long term rates like you would expect. Right now, 5 August, the curve is incredible steep with current interest rates at 3% and 5 year government bonds yielding around 5.5%. This curve indicates there is only one direction for rates to go and that is up...and that is only likely to occur if the economy is strong.

There is no doubt the outlook for the Australian economy and global economy) has improved in recent months, but the speed of the improvement, whether sharemarkets or the strengthening of the above yield curve, has been startling. Whilst yields aren't what they used to be, has this rapid improvement been to fast, so is there a short term opportunity for bonds? If not, then can this yield curve get steeper?

Mutual Fund Theorem - Ignored by most financial advisers

According to John Campbell, Professor of Finance at Harvard, “academic finance has had a remarkable impact on many financial services. Yet, financial planners offering portfolio advice to long-term investors have received curiously little guidance from academic financial economists”.

A case in point is the Mutual Fund Theorem, which was developed by Nobel Laureate, James Tobin in 1958. The mutual fund theorem is a very simple approach to investing based around Harry Markowitz’s efficient frontier framework suggesting that all investors should hold only one portfolio of risky assets. This one portfolio can then be adjusted for the conservative investor by adding risk free assets (or cash), or can be geared for the aggressive investor.

Figure 1 shows the efficient frontier and the Capital Market Line (CML) which is drawn from the expected return of Cash through the tangent of the efficient frontier (represented by the Optimal Portfolio). Whilst it is not a perfect representation of reality, it demonstrates the possibilities that:

• By adding cash (or a risk free asset) to the optimal portfolio (which contains bonds, equities, etc) it is possible to achieve a high return for less risk than a portfolio of bonds…this is the benefit of diversification


• Gearing the optimal portfolio has the ability to achieve a high risk-adjust return than a portfolio of 100% equities. Most of the high growth portfolios include only equities (which clearly may be less efficient than a geared diversified (or optimal) portfolio)

Whilst most if not all financial planners and advisers are aware of the Markowitz efficient frontier and the derivation of the optimal portfolio (i.e. the portfolio with the highest expected return per unit risk), the use of this very simple part of modern portfolio theory has seldom been put into practice. Financial planners throughout the world typically look to personalise portfolios for individual clients based on their risk profile, income and growth needs and most likely looking to build portfolios that are on the efficient frontier. As Figure 1 shows, in theory this may not be the most efficient approach and is potentially creating unnecessary work that adds little to no value in terms of what matters to investors the most, investment returns.

From a practical financial planning perspective, adding cash or gearing an “optimal portfolio” certainly makes things a lot simpler.

Now whilst every investment professional in the world attempts to design an optimal portfolio within their constrained investment universe, we all know that it is impossible, but of course, it doesn’t stop us from trying. For the retail investor the optimal portfolio is often regarded as the “balanced” portfolio, which has a diversified allocation across all available asset classes whether equities, bonds, real assets, etc.

So to really keep portfolio construction simple, recommend the “balanced” fund for the balanced investor and add cash for the more conservative investors and gear into the balanced fund for the growth and high growth investor.

Some of the challenges with implementation include, choosing the optimal portfolio; the limitations of implementation in various investment vehicles such as superannuation where gearing may be difficult; or simply getting cost effective gearing.

Overall, this theorem should provide some food for thought next time a portfolio is constructed and some questions to ask before building the next “tailored” portfolio could be…can a geared diversified portfolio be more efficient than 100% equities or should the client really be out of equities just because they are conservative? At the very least, the Mutual Fund Theorem demonstrates the best method to manage risk is diversification and diversification across all asset classes should be considered irrespective of the investor’s risk profile.

A simple economic/financial update for some planners

Over the past few months the global economy has seen the emergence of “green shoots”. As implied, there are indications that the global economy may be turning a corner. Like turning around a super tanker, turning around the global economy will take a long time and these signs aren’t so much an improvement but indicate a slowdown in the deterioration of the global economy. For example, in the US only 345,000 jobs were lost during May which is around half the average monthly decline of the previous six months. US Unemployment is still increasing but not at the rate it previously was.

Other positives include the gradual decline in the cost of credit (remember the Global Financial Crisis started as a credit crisis), stabilising financial markets, perceived future demand resulting in increasing commodity prices (Oil increased by 48% in USD terms over the past 3 months), and improving consumer confidence.

In Australia, our unemployment stands at 5.7% and the Australian Bureau of Statistics announced that we avoided a technical recession to the quarter ending March 2009 with positive real GDP Growth of 0.4% thanks to declining imports.

For the Australian sharemarket investor, returns for the 3 months ending May 2009 have been spectacular with the broad All Ordinaries Accumulation index increasing by a little more than 17%. Overseas sharemarkets also provided strong returns and the major sharemarket indices of the US, UK, and Japan increased by 25%, 15% and 25% respectively. With the Australian dollar appreciating over the same 3 months against the US Dollar, Pound, and Yen, by 25%, 11%, and 22% only the hedged international investor experienced the strong international gains as the strength of the Aussie dollar most of these returns.

The perceived improvement in the global economy combined with large budget deficits all around the world including here in Australia, government bond yields increased substantially. This means that investment returns for the bond investor were relatively weak (as high interest rates mean lower bond prices). The UBS Composite Bond index had a slightly negative return of -0.6% for the 3 months to May 31, and the global fixed interest index, JP Morgan Broad WGBI (AUD) Hedged Index, returned only 0.43%.

Whilst the short term sharemarket gains indicate positive signs for both the Global and Australian economy, there are still significant signs of weakness. Unemployment both here and overseas is still increasing which will continue to dampen demand and force households into increased savings instead of spending. Business investment is weak and companies continue to struggle, as evidenced with the recent collapse of General Motors and Chrysler in the US, and two of the largest agribusiness companies in Australia, Timbercorp and Great Southern. The last few months have shown the risks of being out of the sharemarket when everything appears to be at their worst. For investors, sticking to a portfolio with the risk profile designed to help achieve financial goals is essential.

Australia's Steep Yield Curve

An incredible steepening of the yield curve has occurred throughout 2009. As can be seen the latest 10 year bond yield isn't too far from where it was in the middle of 2008. This yield curve tells us several things about the state of current markets and economy...

• the market is starting to think that the next RBA move will be an increase in interest rates and not a drop...the 3 month yield is only 2.95% versus the 3% cash rate and longer term yields are above 3%
  
• The steep normal looking yield curve is typically a sign that Australia's economy is looking up and this steepening has increased throughout the year in line with increasingly positive news
  
• The sharp increase in steepness has happened so quickly....does this mean that bonds are oversold?

Overall this is a good looking positive yield curve despite global economic news continuing to be mixed. We are still in the 'green shoots' phase of a global economic recovery so this steep yield curve looks to be a relatively attractive buying opportunity to me.

Today's RBA Rate Prediction

The current September 2009 government bond is yielding 2.77% indicating the market is expecting (most likely) only one more 25bps rate reduction over the next few months. Most economists expect the RBA to stay steady today and given the RBA reduced rates last month by 25bps I also expect it to stay steady as they have indicated in the past their desire to see how their actions are received before reducing again.

The budget is only one week away and it may be packed with enough goodies to provide the economy with a boost but no matter what, the global problems will still overwhelm the Australian government's action so there's a long way to go. With inflationary expectations still very low, I see no reason why the RBA shouldn't cut rates, but I still expect a 3% cash rate tomorrow.

Risks of Fixed Interest Investments

One of the most misunderstood asset classes is fixed interest. Most investors have a reasonable understanding of the risks associated with equity investing but fixed interest is very different. I have created a draft article for use by advisers and discusses the major risks of fixed interest investment in the context of the global financial crisis and its various effects on last year’s returns. Quite simply, interest rate risks positive credit risks were negative, duration risks largely positive, and liquidity risks frustrating!

For those interested my article can be found here ... http://tinyurl.com/ceba9j

Credit Crisis Continues...

Whilst the Reserve Bank drops their cash interest rates the credit spreads (as shown above) on investment grade corporate bonds are doing the opposite. It doesn't matter whether you are a AA, A, or BBB rated corporate you are paying a record interest rate above the government interest rates. It amazing that these credit spreads are almost 2% higher than when Lehman Brothers collapsed. Anyway...I guess this chart explains to a degree why the banks have barely pass on any of yesterday's interest rate cut...because credit is still very tight.

Government Bonds and interest rate movement

The above government bond yield curve shows how the yields have changed across the different terms from early February to today (before the RBA's decision). The 1 year yield is still around 2.60% indicating the market expects the RBA to drop rates to around 2.5% by July 2009 but the interesting part is how the yields have increased from maturities of 2 years and above. With the Australian government's fiscal stimulus packages and expected capital raising from bond issues, the market is demanding a higher premium from the government and yields have increased by around 0.50% to 0.75% for all longer term government debt issues.

From an investment perspective this increase in yield over the last 2 months would have dampened bond returns significantly. But with the economy still deteriorating perhaps the yield curve movement is a little overdone and maybe now there's a buying opportunity???

Deflation...how to invest?

Source: IMF

The above chart shows the IMF's global inflation forecasts and they don't look pretty. They are forecasting that advanced economies might by in a position of deflation similar to what Japan experienced in the 1990s. Many would argue that deflation is just as or almost as bad as high inflation. Deflation is simply the decline in prices and what this means is that if you as a consumer believe that prices will be cheaper tomorrow then you will not spend today and save your money. Not spending means lower revenue today, therefore costs need to be cut, jobs are lost, followed by less spending and the vicious cycle continues.

From an investment perspective, the above-mentioned vicious cycle results in declining profits which is therefore a negative for equities, credit, and as it often leads to near zero interest rates is not particularly good for cash either. The one asset class that is a good place to be in times of deflation are high grade bonds. Because inflation is the bond investor's enemy, deflation is their friend. As interest rates, prices, and profits decrease during the deflationary cycle, high grade bond investors receive a fixed interest rate that doesn't lose its purchasing power but actually increases it.

So whilst, governmet bonds had an incredible run in the 2008 calendar year, with deflation looking like a possibility in 2009 perhaps now is not the time to discount their value in a diversified portfolio.

RBA Cash Prediction

Its the day before the RBA announces its latest cash rate so I thought I'd come in with a late prediction.

Its pretty simple really...September 09 Government Bonds are trading at a yield of 2.82% today so the market is expecting one of two rough possibilities...

1. the Reserve Bank drops the cash rate by 50bps to 2.75% and keeps it there for the next 6 months, or
2. the Reserve Bnak drops it by 25bps tomorrow to 3.00% followed by another 25-50bps between April and June and keeps it at 2.75% through to September

I'm not sure what the probabilities are between these 2 possibilities, but I predict that option 2 is most likely. So for the record, the RBA will drop rates by 25bps on March 3 and will probably drop another 25bps in April. I personally believe these won't be the only rate drops this year but the market is expecting different so who am I to disagree.

With August 2010 bonds trading at a yield of 2.76% it appears the market is a little more optimistic than it was a few weeks ago and perhaps expects a cash rate low of only around 2.5% which is a significant increase from a previously expected low of 2.00%. Perhaps things are looking up in Australia.

Mortgage Funds - still $1???

I've had enquiries from numerous advisers wanting to invest their client's money into mortgage funds. Thanks to the Rudd Government's deposit guarantee many mortgage fund investors decided to redeem their funds and shift to the more secure bank deposits. Unfortunately for the funds and their remaining investors the level of redemptions were so great, the funds had to suspend all redemptions. Now we are left with the funds drip feeding redemptions to investors and one of the last redemption reports I heard was that investors only received 30% of their requested redemption and will have to wait for the remaining funds when the next window opens.

With the global credit crisis and resulting decline in interest rates, mortgage fund's income return now looks quite attractive as many funds have a large book of fixed rate mortgages. Whilst they look good, credit spreads are still enormous and whilst these funds aren't taking on any new borrowers (the redemptions took care of that) they are still rolling their good borrowers at fixed interest rates of at least 9%! Very nice in this environment if you can get it.

What I would like to know is...how can a mortgage fund still price itself at a fixed $1 per unit? The clear lack of liquidity of these unerlying investmetns combined with the massive movement in credit spreads over the last 18 months does not suggest that mortgages price is static. Certainly mortgage backed securities on the over-the-counter market have had a shocking run since the credit crunch began in mid-2007 so to still suggest a $1 price is ludicous.

Clearly the funds do not know how to price these securities with any accuracy, but given the lack of demand for these securities and credit blow-out, if you want to invest at $1 per unit then I suggest you are paying way too much. The interest rate is not anywhere as attractive as it needs to be given the increased liquidity risks and current economic environment.

No Relief yet for those looking for longer term loans

In recent weeks I've spoken with a few people who were waiting for the Reserve Bank to drop cash rates before looking to fix their mortgages for the long term. The chart above shows the change in government bond yields from last Thursday (29 January) to today (3 February) after the Reserve Bank dropped interest rates from 4.25% to 3.25%. Despite the massive drop in the RBA Cash rate to the lowest level since 1964, there is very little change in the longer term government bond yields. In fact, if anything the yields have increased slightly.

Given fixed rate loans are related to the longer dated part of the yield curve (really up to the 5 year mark), those looking for lower interest rates on longer term loans like car leases, fixed rate mortgages, personal loans etc. may have to wait a little longer before there is significant change.

Thoughts on the outlook for bonds

Bonds were not surprisingly the highest performing asset class in 2008. Advisers can expect increased promotion of bonds by BDMs and fund managers and the issuance of new products (eg the new Vanguard Australian Government Bond Index Fund). What is our view?

· Australian Bonds: Neutral, with a likely move to underweight
· International Bonds : Underweight

The headline in the recent Morningstar performance league table was something along the lines of “Australian Bonds best performing asset class since 1992” with a return of 14.95%, but what about 2009?

Last week, Vanguard launched their Australian Government Bond Index fund after the “Commonwealth Bond >10 years Accumulation index“ had an enormous return of 27.72% in 2008. However with government bond yields currently at their lowest for many many years (and therefore their highest price) is this the latest bubble?

At the time of writing (January 27), Australian government bond yields that mature between 1 and 15 years range in yields between 2.54% and 4.16% so if held to maturity then these yields are the highest returns that can be expected. However, what is in favour of the bond investor is that it is possible for bond yields to fall much further. Australian yields are much higher than those overseas where the 10 year US Government bond trades at a yield of 2.64% and in the UK, 3.70% (compared to Australia’s 4.16%). With China’s economic growth slowing rapidly, it is looking increasingly likely that Australia will go into recession and this could well result in lower bond yields and therefore higher prices. Overall, the combination of record high bond prices with an economy under pressure means the outlook for Australian bonds is “Neutral” with an expected next move as "Underweight" … but not quite yet.

Global bond prices, on the other hand, have very little room to increase. US cash rates are effectively at zero, so too is Japan, and Europe isn’t far behind. As already mentioned the longer term yields are also very low. After a solid 2008 annual return for hedged global bonds of around 13.5% (according to the Citigroup World Government Bond Index), the downside risks appear far greater than the upside potential so the outlook for hedged International bonds is “Underweight”.

Bonds typically perform best in a deflationary environment whereby a dollar today is worth less than a dollar tomorrow. Should the outlook for the global economy move towards deflation then it is likely the outlook for bonds will be more positive than the current view.

What will the RBA do next?

If you want know what the RBA is likely to do next, there is probably no better chart to look at than the yield curve of Australian Government Bonds. With the lowest point being around 2.75% at the 2 year maturity and the 15 year rate barely above 4%, clearly the market believes rates are going to stay much lower than the current 4.25% for a long time.

As for next steps, given a 1 year (which really matures mid September 2009 … just 8 months away) bond yield of just under 3%, the market expects the RBA to lower rates down to 2.75%, possibly lower, sometime over the next three to four months.