Since the COVID flash crash during February and March of 2020, equity markets have staged an incredible comeback well exceeding previous highs of the pre-COVID era. Most investors do understand that this is not a free lunch but instead is a direct consequence of continuous money printing with many investors following the TINA principle - "There is no alternative" leading them to throw caution to the wind and invest further. Now let's say you are starting to get concerned about developed market equities at their current 'nose bleed' valuations - do you then simply de-risk your portfolio by selling equities and buying bonds, or does that in itself present a range of unintended risks?

The answer in our opinion is that it depends on what bonds you are buying. Traditional asset allocation theory does state that when equities are expensive, you should buy bonds. But what if bonds are also just as expensive? This is the conundrum to explore now.

Source: Vanguard Factsheets and Premium China Funds Management (July 2021)

How can bonds be expensive I hear you ask? While bonds are issued by governments at $100 each and when they mature they pay you back the $100 as long as they haven't gone bust; during their lifetime, they can and are trading on bond markets (just like shares) so their value fluctuates. When you then combine this with the inverse relationship of interest rates falling leading to bond prices to go up, you start to see how things can go wrong.

Remember the traditional asset allocation theory of switching from equities to bonds? Well, this assumes that bond interest rates are high, not low. Structurally, we've seen bond rates fall at a consistent rate for the better part of 40 years to where we are now - effectively zero! As rates have gone down, bond prices have gone up leading to them being valued by the market higher than their issue price (and the price you will get back at maturity).

So using the example above, a well-diversified Australian government bond portfolio is showing that if you want to invest, you will on average pay $116 for these bonds, well knowing you will only receive $100 when they mature in approximately 7.4 years time. Putting it in another way, if you believe the Australian government won't go bust, you will loose just under 2% p.a. over the next 7 or so years by holding the bonds. The only offset you will receive is that each year, those bonds will pay you a 2.80% coupon, meaning your net return to be 0.83% each year for the same 7 or so years. The lightbulb is now clicking I hear!

There is also one small complication, remember that when interest rates go down, bond prices go up? The opposite is also true, given we are at effectively zero rates, bond prices will go down when rates eventually go up. Remember, its not a matter of if, but a matter of when.

So going forward, when considering an investment in bonds, you should consider one which can win in more than one way, which is buying bonds at less than $100 face value and as they near maturity will get closer to $100 so that you can make a capital gain while also picking up strong levels of income. Asian corporate bonds as we see it can provide this, with a cash yield of over 7% with the additional opportunity to make modest capital gains on top of this.

My final message is simple - bonds have only been defensive based on history, and history will be re-written when rates go up. But for the time being, have a look at your own bond investments, and ask yourself, are they really defensive?