Europe debt crisis pushes up Aussie bonds

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Like the Greek election before it, the election in Italy last week resulted in an inconclusive outcome with neither of the major parties able to form government. The likelihood of a loose coalition of disparate political foes being cobbled together left markets underwhelmed with the resultant ‘flight to quality’ – here we look at what the flight to quality actually looks like.

When in Rome?

With neither Pier Bersani’s centre-left Democratic Party, nor Silvio Berlesconi’s centre-right Forza Italia party able to win a clear majority in the election (and Beppe Grillo’s Five Star movement committed only to a referendum on Italy’s continued participation in the Eurozone) markets turned their attention back to the European debt crisis leading to the inevitable flight to quality.

Whilst markets are more comfortable with ECB efforts to stabilize the union, compared to where they were when the Greek election failed to deliver a decisive outcome last year, Italian bonds were still sold off hard in the week following the election, with yields on Italian government debt blowing out 50 basis points.

In 2012 ECB President Mario Draghi proclaimed the bank would do “whatever it takes” to maintain the European Union and the single currency and markets both in Europe and abroad saw this as a strong indicator to add risk, with both equities and bonds in weaker economies performing well.

However following the Italian election, markets began to reassess the detail of what Draghi had said and they didn’t necessarily like what they saw. In particular, markets focussed on the caveat that ‘whatever it takes’ was dependent on governments playing ball, something not necessarily guaranteed under the new Italian political landscape.

Comments from Germany’s political leaders (as the Italian vote against austerity was very much seen as a vote against Germany) with its own election due in September ramped up the pressure and with markets again concerned by risk – or potential – investors looked to take risk off the table, leading to an inevitable flight for quality.

What does it really mean?

The term ‘flight to quality’ is used often, but what does it actually look like. The graph below shows the change in nominal bond prices for Australian Commonwealth Government bonds (ACGS) compared to the change in Italian Government bonds (BTPS) the week following the election. I have used a 2022 maturing bond from each for the comparison.

Markets were selling assets perceived as risky – i.e. Italian bonds – and purchasing assets perceived as safe – including AAA-rated Australian bonds (US Treasuries also showed increases in the week). This change in demand for the bonds pushed the price of the Australian bond up, and the price of the Italian bond down. The capital price of the Australian bond gained 1.6% in a week whilst the Italian bond lost almost 3% the same week. This is the outcome from a flight to quality.

The takeaway for investors

So why should SMSF investors care? As to the machinations of Italian politics, or the daily bond trading of global markets, the SMSF investor should only take an interest in the key macro messages; is the European debt crisis really settled? Is risk really off the table?
What is perhaps more important for SMSF investors is that they keep the mantra of ‘diversification’ front of mind at all times, even when equity markets are enjoying a strong run.

Many SMSF investors, particularly in their fixed income allocation, look only to yield when making their investment decisions, however this ignores the other benefits fixed income provides to a portfolio. The key benefit the focus on yield ignores is the balancing, or ‘portfolio effect’ fixed income delivers. The portfolio effect is best provided by the lowest risk securities, as when markets are in crisis, and risk assets (like equities, property and even a lot of hybrids) are performing badly, markets make a flight to quality, which leads to a lift in their capital value.

We saw this with Commonwealth government bonds last week. Their yield of 3.28% may not appear attractive on the surface, however they offer more than yield, they offer protection when the rest of your portfolio is underperforming.

Of course, when the rest of your portfolio IS performing, Commonwealth bonds are likely to underperform, but that is the trade off – smoother returns over the long run versus lumpy returns dependent on markets.

In an SMSF, and in particular for investors approaching or already in retirement, I would suggest smoother returns should be an investment goal, chase lumpy returns in your personal investments, not your retirement investments. This is the reason professional super investors hold government bonds in their portfolios and it is the reason SMSF investors should follow suit.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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