KEY POINTS:
Investment markets in 2008 would probably have confounded financially literate Martians observing the action from deep space. Martian financial theory, like our own, no doubt argues that higher risk assets should produce the highest returns.
All very sensible except that it didn't happen last year - quite the opposite in fact. Risky assets had a dismal year with virtually every asset class recording losses from international shares at -40.3 per cent, to global property at -48.85 per cent, to commodities at -35.04 per cent, in US dollar terms.
Just about the only way to make money in 2008 was by owning bonds. And not just any bonds - only the lowest risk cut the mustard.
In calendar year 2008 10-year NZ Government Bonds returned a whopping 19.9 per cent and 30-year US Treasuries achieved a truly out of this world 41.2 per cent.
You might think that with this fortunate backdrop fixed interest assets would have been the saviour of Mum and Dad's investment portfolios last year, but sadly, more often than not, this was not the case.
Low-risk bonds enjoyed substantial price rises as yields fell. Conversely, more risky bonds, even those with just an element of risk, either fell in price or went nowhere.
In any event the corporate bonds and finance company debentures frequently favoured by financial advisers in New Zealand, even if they managed to avoid going bust completely, largely missed the fixed-interest party.
Inflation was at least 3 per cent a year and, with oil prices skyrocketing, locking into 4.45 per cent a year for 30 years looked like madness.
Roll forward 12 months and inflation is out the window, no one wants risky assets and the yield on 30-year treasuries is now down to 2.7 per cent, to give a total return of 41.2 per cent in a year. This 41.2 per cent is made up of the original yield of 4.45 per cent and the rest is capital growth as the price of the bond rose as yields dropped.
To put this in perspective a look at the 2007 Stocks, Bonds, Bills and Inflation Yearbook shows that 2008's 41 per cent return is the second best calendar year performance since records began in 1926.
The best year ever was 1982's 42 per cent and the average return for long dated Government bonds from 1926 to 2008 is just over 5.4 per cent a year.
Unless our Martian friends have a time machine this information wouldn't be of much practical help, except perhaps that it warns that the people who move the financial markets must be pretty worried about the future to accept such a low return as 2.7 per cent a year for US Government bonds for the next 30 years.
New Zealand Government bonds benefited too from the flight to safety and the effect of the yield on 10-year Governments falling from 6.4 per cent to 4.6 per cent produced, together with the income payments, a total return of 19.9 per cent.
The March 2012s from Fletcher Building are reasonably short-dated bonds so even though their market yield has dropped slightly from 10.1 per cent to 9.1 per cent, the impact on the price isn't great because they only have a few years to run. Even so total return is a handy 12.7 per cent, but unlike the 30-year US Government bonds, the bulk of the return comes from interest payments rather than capital growth.
Next up are the Infratil 2020s. These are a long-dated bond but unfortunately the market views them as being more risky now than at the start of the year, so while interest rates on low-risk bonds have gone down, the margin over the risk-free rate which buyers of Infratil bonds demand has increased.
This increase in margin has overwhelmed the cash yield which has increased from 9.85 per cent to 10.0 per cent. This has the effect of lowering the price of the bond substantially so that the total return to holders of Infratil 2020 in calendar 2008 was just 0.4 per cent in that the price fall offset almost all of the interest payments made in the year.
Last and certainly the least bond is the unfortunate Babcock & Brown November 2011s. Babcock & Brown looks like it might go down the gurgler, so the yield on its bonds have jumped from 10 per cent in January to 295 per cent in December.
The fact that the market prices these bonds to yield 295 per cent doesn't leave much doubt as to where the stock is going - oblivion. Remember though that the way the market gets to 295 per cent is by the price of the bonds falling. Babcock & Brown are still paying the same amount of interest - it's just that the price of the bond has fallen from 87.1 cents to 4.38 cents.
What might our Martian friends make of the Earth's bond market of 2008? Firstly, they might observe that the initial interest rate or market yield isn't a good indicator of total return - NZ Government bonds yielding 6.4 per cent in January substantially outperformed Infratil 2020s yielding 9.85 per cent.
Because fund managers are conscious of the effect of fees on low-yield bonds, most managed funds are light on low-risk bonds, so it is a good bet that in this environment no managed bond funds will have outperformed the Government stock index in 2008.
Secondly, wise Martians might recall that earthling Tim Bond from Barclays Capital has told us that bonds exhibit serial negative correlation; that is, good years are often followed by bad years.
Thirty-year Governments returned 41 per cent in 2008 but they have had some bad years too, like 1969 and 1999, when total returns were minus 10 per cent.
Thirdly, if the Martians were looking at bonds from the perspective of their help in diversifying a portfolio of equities, they would see from our recent experience that they need to concentrate their resources in genuinely low-risk bonds. Higher-risk bonds often morph into shares at the first sign of trouble and drop in price.
Anecdotal evidence suggests that many local retail investors - DIYs and those with managed portfolios largely - missed out on the 2008 bond bonanza because often their advisers concentrated on selling corporate issues paying higher brokerage fees.
Similarly, genuinely low-risk bonds frequently never make it to advisers' radar screens as they perceive them to be unable to sustain annual portfolio management and monitoring fees, which means investors miss out on the returns of a year like 2008.
High fees force investors and advisers into high risk. This strategy was disastrous in 2008 as evidence suggests that very few individual investors benefited from the bull market in ultra-safe bonds in 2008.
Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.
