ON ASSET ALLOCATION

pw - One of my clients has got a private banker in Europe and he’s always astounded at the Australian market versus the European market. I think because it’s a lack of necessary knowledge and also the diversification aspect. So, his private banker would put him in single issuing bond. It’s very actively managed by private bankers, so from a legislative perspective I might go in and take a yield and then as soon as something happens you’ll be able to get it out without actually having to do a statement of advice. He’s very active in that.

In the Australian market, it’s advisers. That’s [bonds] one part of what you’re actually doing with a client. It’s a purposeful decision on how active you actually want to be in there. And also, you’re getting a pretty good return for dividends – it grows. The coupon depends where we are in the interest rate cycle. It’s developed from fixed and floating over the last 15 years, so you can mitigate that interest rate risk. If it ain’t broke people don’t want to fix it. They don’t want to change as advisers.

tf - I’m on their side. I think the mystery is: why is everyone else’s allocation to equities so low? Most of their savings is financing retirement. Typically, in the old days, you used to retire and die within a few years. But these days you probably get 30 or 40 years. I’m not sure if it’s the growth income thing. You’ve got the time to get the high returns that tend to come with equities. And so, the mystery for me is why are people sort of loading up with the government bonds that pay negative interest rates? Why would you bother? So, my sense is Australian businesses have gotten it more or less right, the mix between bonds and equities. The questions I have are more about how do they actually go about putting it together?  

pm - That would be right with SMSFs, because most of those are not actively managed. I mean, they puff their chest out and walk around saying they’ve got a self-managed super fund and they don’t even know what it is. Or if they put a couple hundred grand into term deposit and the accountant’s made five grand by setting one up, charges for an annual audit, well, they’re no better off. I mean, that’s a false way, I think, to look at the pot with the SMSFs. The fair wedge of those are uneducated and not proactively managed accounts.

js - I think in that circumstance they need good advice.

 

ON CORPORATE BONDS

ts - So Tim, you talk about government bonds and that’s one thing, but what about the understanding of corporate bonds by Australian investors?

tf - My sense of advisers is they make the decisions between equities and don’t spend nearly as much time thinking about how to invest in the secure part of the portfolio. Where do they go down the credit spread? Is it all going to be in hybrids? Is it a mix of different things? How do you make the most of your opportunities? My sense is the approaches are pretty lazy in a lot of advisers.

ts - It sounds like there is a lot of laziness. The SMSFs have got 25 per cent of their portfolio in cash and they’re lazy, and there’s some complacency on the part of advisers when it comes to things like corporate bonds.

tf - Better to call it inertia.

pw - It’s about how to do it. So, most people grow up and they know how to buy property. You go to a real estate agent. You go see a solicitor to do the conveyancing, you go to the bank to get the money and it’s done. Then the real estate agent does it. They don’t actually have to think about that. There’s a lot of Australians that actually have CBA shares and IAG shares and NIB shares that still have them because they don’t know how to sell them. They actually don’t know how to open an account. That’s something that’s been around for a while isn’t it? We’re talking about how people understand corporate bonds.

The other part with bonds is where we are in interest rate cycle. Just if it’s fixed. Then you’re actually mark to market and the price goes down. Not many investors understand that concept; no matter how much you actually put in the money section of The Sydney Morning Herald and all magazines and so forth. They don’t understand. You watch a client’s eyes glaze over when you talk about bonds and inverse pricing – that yields go up as prices go down. They’re in Bali. They don’t understand. They don’t care because they are paying the adviser to manage all that and they don’t want to lose money. It’s all about education and investors generally don’t want to hear it. They only want to hear that Woollies is actually making a profit so they get a better dividend and the price goes up.

js - I’ve been interested in your conversation you’ve had with your clients. The ASX peaked at 6,700 in July of 2007. It’s scratched over 6,000 10 years later. Dividends have essentially cropped up. If you bought the index you are still 10 per cent underwater. How do your clients feel about that? Do they even know that?

pw - The issue is where we are at in the cycle right now. Most people who were whinging during the GFC around having not enough cash, when I’m telling them to actually have more money in their cash bucket they’re bucking and squealing because they don’t see that they actually need it. So, they’re educated clients who went through the GFC, long-term clients of the firm and I’m having to argue with them to put more money in cash, put hay in the shed for down the track. Most investors have actually forgotten about the GFC.

ON THE BENEFITS OF BONDS

ts - It was a long time ago. Nearly a decade ago. You don’t see the benefits of things like bonds and protection in your portfolio until you need them.

pm - It’s because things like that happen that you do need them. The Japanese understand this way better than we do. That you can go 10-15 years in the equity market and go backwards. It happens. The Americans have seen it. It does happen. That’s why you need this stuff.

ts - What about moving money into something like individually managed accounts that deal in corporate bonds?

pw - That’s a separate educational part. Because that’s actually moving money out of risk-free into risk. That’s not the money. You actually want the money where people are actually investing in the Pimco bond fund. Or from cash to the Vanguard. It would be a very deliberate decision. The thing that you have to do is actually work out where does the opportunity sit? And how would I actually lead those people out of that particular product and why? And how is that actually a better solution for the adviser and for the client?

 

OWN YOUR AGE IN BONDS?

ts - So, whether you have a Pimco bond fund, an IMA or whatever, going back to thinking about asset allocation, what do we think about this idea of ‘own your age’ in fixed income, which is kicked around a fair bit. Is that an idea that has any merit?

rr - No, not at the moment. The rates are just too low to own your age at fixed income.

tf - Well, I mean for some people it makes sense, for some people it makes no sense at all.

pw - The amount that’s in defensive, or ‘secure’, is a function of what that client actually wants.

rr - But if you’ve got a 40-year-old with 40 per cent fixed interest, and he’s 25 years away from retiring, another 30 years of living, you’re just not going to get there.

pw - Depends on the entity that you’re advising. If it’s a super fund and I can’t access it, it’s stupid. If it’s in their personal portfolio and they’ve got stuff that they’re wanting to do, it might actually make sense to have 40 per cent.

pm - They’ve got to reach their common goals, that’s a good example. A 40-year-old is not halfway through their life. You’re talking about a timeline there. Growth, for sure. It’s going to be a long time in retirement, there’s going to be a lot of loot needed. Yeah, you’ll need exposure to those growth assets.

rr - I don’t know. For my clients, I’m sure I’m the same as anyone else, but people love Australian shares. They’ve just got a love of those assets. I can sit there and say to the client, the ASX nearly reached 7,000 and we got down at 3,111. But we’re not back there yet but yes, we’ve had income, but we’ve always had income paid out until we reach the high, there’s always been dividends, and we tax them favourably. So, I think most of my clients have become complacent with risk. They just don’t care anymore. They’ve seen everything, and they just don’t care.

pm - I think we have an obligation though to be changing the story there. We need to be educating them that what’s gone on before might not necessarily be what we’re going to get into the future. Certainly, pre-positioning them and pulling their expectations down.

What goes around comes around, and that day will come again. One thing we’ve been doing, particularly with the retirees, is sort of pumping up the cash accounts, 12 months out up to two years. We’re strengthening that buffer. You’re looking to erase the need to have to sell – top up the cash account to keep paying for the income. The things we can do and explain that to the client, that’s good news.

ON FIXED INCOME AT THE RETIREMENT CROSSROADS

ts - We’ve been talking about how it all depends where the client is on their journey as to where the asset allocation is. For a client who’s perhaps approaching a retirement, how do you start thinking about the asset allocation?

pw - It’s a function of what they want. Because the biggest destroyer of wealth is selling assets at inappropriate times at inappropriate prices. That’s how you destroy wealth. You tell someone down the barrel, you say, BHP was $50 dollars but it’s now $30, but I need to sell it at $30 to put money in your cash account so you can buy food this week. They’ll do it, but they’ll hate it, because they know that it was earmarked at $50.

pm - And you’re just magnifying the loss that the market has already given them anyway.

pw - So, if you have that secure part and that composition is bonds and hybrids and all the bits and pieces, that’s the composition in that. And everyone’s fighting for that.

ts - How does a big market crash, like the GFC say, what does that do to investor mindsets about bonds and fixed income? What are they thinking immediately afterwards, and what kind of conversations do you have?

tf - Well, if they’re being advised, they would be reasonably educated that markets do go in cycles, and we’ve had this previously, you’ve gone through them, this is another. What we don’t know is the depth of it or the length of it, but you’ve been through them previously, we’ve spoken about it.

pw - We’re in a different bit of the market. I remember going into the GFC I had a bond manager in our portfolio and it was doing badly, it was generating 2 per cent. The cash rate at that time was 4 per cent. The number of times I was on the phone actually explaining to people it’s in there for this reason, this is abnormal where the cash rights are actually greater than bond yields. But when it turns to custard, that thing is actually going to fly, and you’re going to thank me. I had that conversation for about eight to 12 months, then the GFC happened and that same bond fund was delivering 12 per cent and everything else was going backwards.

And you just need them to remember that 10 years later.

They have to remember that. You paid me for advice, and I’m advising you. You can do what you want. Either you’re going to be right or I’m going to be right, it’s a binary outcome. You’re paying for my advice, so I say stay the course, you need that in your portfolio. Even though it looks like it’s doing terribly, that is what you actually need now.

It’s really interesting isn’t it, because a lot of the work we do for people in the retirement phase, essentially is they will build a bond portfolio or cross some inflation, make fixed rate bonds, floating rate bonds, and it’s the coupons that generate the income. And they can know from those coupon packets exactly what date that money’s going to hit their account, what month and they can sort of build their lifestyle around that income coming in. It’s certainty.

In that retirement phase, if you’ve got that sort of certainty of your performance and return, does that minimise the need for the ‘three years of cash’ account? You’re getting into that period in retirement where you can now start to rebalance.

pw - So if you’re asking an adviser, no. It doesn’t replace it. If you ask a retail person, I’m sure you can convince them. The issue is that where we are in the current part of the cycle, very few people in this country have got enough capital to just rely on having a lot of money sitting in secure assets. They need a higher rate. If you had $20 million, and you just wanted to live off a hundred grand, yeah, I’d just chuck it all in there.

sm - Then that’s that sort of, how much risk do you take to get that extra return? Do you chase it through risk or do you chase it -

tf - Let’s say the last 30 years you’ve had 6 per cent out of your ASX top 50 bonds. What chance would you reckon of getting 6 per cent in the next 10 or 20 years? It’s either zero or marginally higher. It’s a meaningless number. You are not going to get 6 [per cent] from here.

js - Going back to my point about the equity market as well. I read all sorts of guys who model the S&P500 against all sorts of stuff. They’ve done it, back tested it, and they reckoned the S&P500 is going to do between 1-2 per cent over the next 10 years.

tf - I reckon it’s 3.5 per cent.

js - You can quite easily get that in the Australian corporate bond portfolio with a tiny amount of risk.

tf - I would say one, why buy US equities? Two, the equity market is only yielding, at the moment, about 6 per cent. If I get any growth at all, I’m a fair way ahead of two, which is what I’m going to get out of cash. I’m a long way ahead of three, which is what I get out of term deposits.