August was a weak month for equity markets with continued concerns over trade tensions between the US and China. While equities sold off bonds, ‘bond proxy’ assets such as property generated positive returns. For the year to the end of August Australian bonds, as represented by the Bloomberg AusBond Composite 0+ Yr Index, returned an impressive 11.2%, outperforming Australian equities. Despite bond yields being at low levels and valuations generally indicating that bonds are overpriced, bonds have continued to provide diversification to equities in downmarket periods.
We continue to believe that bonds play an important diversification role within managed portfolios, despite valuations remaining high. From a portfolio perspective, the primary role of fixed income assets is to provide diversification, with the secondary role being to generate income. Lonsec’s portfolio construction process employs a fixed income allocation within the portfolios to provide a diversified exposure to duration, credit and absolute return bond strategies. We caution against ‘chasing yield’ in the defensive part of the portfolio as most high yielding bond assets tend to be correlated to equities, which work well when equity markets are performing well, but on the reverse will move directionally with equities in an equity market pull-back. In our most recent Asset Allocation Investment Committee, we did not change our allocation to bonds but we increased our exposure to ‘bond proxy’ assets such as global REITs providing some more defensiveness to the portfolios.