It’s often said that part of a portfolio should be allocated to government bonds due to their safety and low or negative correlation to equities. Is a government bond ASX ETF still a good option in a low-interest-rate environment?

About ETFs

Exchange-traded funds, or ETFs, are investment funds that are listed on a securities exchange. They can be managed funds or index funds, or in other words, active or passive, and the fees are usually lower than an unlisted investment fund.

To learn more about ETFs, check out the Rask Finance video below or take a free course on the www.raskfinance.com website.

Typically, ETFs give an investor exposure to many different shares or assets with a single purchase, offering one of the quickest and easiest methods of achieving diversification. The Best ETFs Australia website provides a list of all ASX ETFs.

Why Government Bonds?

There are plenty of Australian government bond ETFs to invest in, including the BetaShares Australian Government Bond ETF (ASX: AGVT), the Vanguard Australian Government Bond Index ETF (ASX: VGB) or the iShares Treasury ETF (ASX: IGB). But why government bonds?

Australian government bonds provide several benefits to investors. The first benefit is a high credit rating. Australian government bonds have a AAA credit rating -– the best you can get –- meaning the risk of default is deemed to be very low.

You won’t find this sort of security when you’re investing in corporate bonds or even government bonds in a lot of other countries. With this high credit rating comes a lower coupon/income rate than what you would receive from other bonds. You’re taking on less risk, so you’re going to end up with a lower return.

However, government bonds still provide regular income that can be attractive when you look at it from a risk versus reward perspective.

Government bonds also provide diversification because their returns tend to be negatively correlated to equities, meaning when the share market falls, bonds tend to increase in value.

Diversification

To understand why government bonds may no longer be an attractive investment, it’s important to understand why they are usually negatively correlated to equities.

Government bonds don’t just rise in value because the share market falls. It’s all to do with interest rates. When the Reserve Bank of Australia (RBA) cuts interest rates, the value of bonds increases because of an opportunity cost. The bonds you hold now appear more attractive because the coupon rate on offer is superior to what you could get investing in new bond issues.

This is why bonds tend to perform well when equities are falling. These are usually times in which interest rates are cut and investors reallocate towards bonds for the security they offer.

The BetaShares ETF mentioned above, AGVT, tracks an index called the Solactive Australian Government 7-12 Year AUD TR Index.

This index vastly outperformed the S&P/ASX 200 (INDEXASX: XJO) between February and December 2008, January to December 2011 and February 2015 to February 2016.

The similarity between all three of these time periods is interest rate cuts, the largest of which came between February and December 2008 when interest rates were cut from 7% to 4.25%. In the following two time periods, interest rates were cut again but by smaller amounts, and government bonds outperformed again but also by smaller amounts.

In other words, the outperformance of government bonds is dependent on how many times interest rates are cut.

Low-Interest Rate Environment

With today’s cash rate at just 1%, it’s questionable whether these events can repeat themselves any time soon. Assuming the RBA won’t introduce negative rates, which is not impossible, they only have 1% to work with and cutting by 2.75% like they did in 2008 is not an option.

With rates already so low, I believe it’s unlikely that government bonds will perform as they have in the past because the factor that fuels their appreciation is quickly running out.

While I can appreciate the benefits of a small allocation to government bonds, I don’t believe it makes sense to allocate any large portion of a portfolio to this asset class right now when meaningful appreciation looks unlikely and the yield is so low.

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Disclaimer: Any information contained in this article is limited to general financial/investment advice only. The information has not taken into account your specific needs, goals or objectives, so please consider consulting a licenced and trusted adviser before acting on the information. Please read The Rask Group’s Financial Services Guide (FSG) for more information. This article is authorised by Owen Raszkiewicz of The Rask Group, which is a corporate authorised representative No. 1264179 of Strawman Pty Ltd (ACN: 610 908 211) (AFSL: 501 223).

Disclosure: At the time of writing, Max does not own shares in any of the companies mentioned.