Current bond market reflects uncharted waters

Rough ride: Most government bonds in Europe are now yielding negative returns, but under European law, pension funds are forced to invest in them.
Rough ride: Most government bonds in Europe are now yielding negative returns, but under European law, pension funds are forced to invest in them.

Rates have been lowered again. It's a wakeup call to think about rates in general and the bond market in particular.

Bonds are an investment that few investors hold in their own names, but anybody with superannuation will have part of their money in bonds, as they are a normal asset in a balanced fund.

Just keep in mind that I am talking about government bonds - not investment bonds, which are tax-paid investments just like your superannuation.

A bond is an investment that is normally made for a fixed term, with interest paid on a regular basis, and the capital value repaid in full on maturity. If you bought an Australian $100,000 10-year government bond today, you would have a promise from the Australian government to return your capital of $100,000 in 10 years and pay you interest at 1 per cent per annum for as long as you kept it.

That's a lousy return, but those who like bonds point out that your capital is guaranteed by the government. Still, with inflation, that $100,000 you will receive in 10 years will probably buy much less than it would today.

The thing about bonds is that their market value increases as interest rates drop. Obviously, if I have a government bond paying 4 per cent per annum, and rates drop to 2 per cent per annum, the value of my bond will rise, because 2 per cent has become the current going rate, and my bond is paying 4 per cent. So in the last 10 years as interest rates have gone down and down and down, bonds have had a bull market. In the past year, European bonds have returned 9 per cent.

But those days are gone. Most government bonds in Europe are now yielding negative returns, but under European law, pension funds are forced to invest in them. Therefore, fund managers are investing heavily in bonds which they know they will lose money on.

Surely interest rates cannot fall much further in Europe! Once rates reach negative territory, savers are penalised for having money in the bank. What's more, as I pointed out recently, home borrowers in Denmark are now having interest paid to them by the bank, instead of them paying the bank. I reckon rates will either stay where they are, yielding a tiny negative rate, or start to rise again.

Here's the crunch: the moment rates start to go up, bonds will enter a bear market and their values will tumble. The pension fund managers in Europe will be stuck with owning financial instruments with a negative interest rate, at the same time as the capital value is falling. It will be a bloodbath. Bonds will not become worthless, because there is still a guarantee of the capital value of maturity, but some of these have a term of 50 years.

So what are the alternatives? Cash, property and shares; cash is yielding next to nothing, leaving us with property and shares.

The thing about property is that it has a sense of permanence, and should increase in value if it is a quality building in the right location. It should also continue to produce a good income from rents.

Now think about shares - when you own a share, you are owning part of a business. Even if there was a bond crisis, the businesses whose shares you own should still prosper, and keep paying you dividends. This is why I think that good property and good shares will continue to do well, provided you stay in there for the long term.

Just remember we are in uncharted waters. Give yourself some safety by keeping enough cash on hand for three years' planned expenses.

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Question. I earn $78,000 a year. I am turning 60 and want to continue to work for at least five years but with reduced hours. My home is worth $700,000 with a loan of $100,000 which I foresee discharging by the time I fully retire.

I have $450,000 equity in a SMSF property worth $550,000 in North Sydney. It earns a rent of $380 a week.

My thoughts are to sell that property, close the SMSF, then deposit the proceeds into a retail or industry superfund, and keep on salary sacrificing to it while I work. I would appreciate your opinion.

Answer. As you are not 65 years you cannot convert your superannuation fund to a tax-free pension fund until you satisfy a condition of release. Therefore, there may be capital gains tax consequences. If your super fund sells the property while it is in accumulation mode CGT would be at the rate of 10 per cent. You would need to do the sums taking into account the potential of the property, and any CGT that may be payable on sale.

Question. With regard to moving into Aged Care Homes.

If we assume the R.A.D. has been paid and provided one has the funds to pay the daily fees, would it be wise to give away the balance of one's assets to reduce the daily fees as they are means tested? It also might be possible to qualify for a part pension with all the applicable benefits.

Answer. Age Care Guru Rachel Lane says that Gifting assets to reduce your aged care costs and increase pension entitlement is a strategy that won't have much immediate benefit. The gifting limits allow you to give away a maximum of $10,000 per financial year, with no more than $30,000 in five years, gifts beyond this are considered a "deprived asset". Deprived assets are treated like a financial investment for five years from the date of disposal - that is the asset is assessable and income is deemed as if it was earned. Beyond the five years the asset and income are no longer counted. If the assets you are gifting are financial assets then really there is no change in the short term, but if the assets are not financial for example a car, boat, land or a house then such a strategy could make the situation worse. Gifting within the limits, pre paying funeral expenses and purchasing long term income streams which have favourable asset test treatment may be worth exploring to gain an immediate benefit and perhaps most importantly keep control of your money - you never know, you may need it!

  • Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. noel@noelwhittaker.com.au