Why bonds inflows are higher than shares

Australian investors put more money into bond funds than share funds in the last quarter of 2022. What is happening?

ASX data shows $747m was invested into Australian bond ETFs in the three months to December 31.

When it comes to tracking investment trends, financial data can be useful to a point. But it rarely tells the full investment story.

Take the surge of inflows from retail investors into ASX-listed exchange traded funds that invest in Australian and global bonds, which are classified as fixed-income securities.

Bonds are issued by governments and companies to raise capital, and investors can expect to receive full repayment of their principal if they hold them until maturity as well as steady regular interest payments.

As such, they’re generally considered a lower-risk type of investment compared to shares, which can’t offer any expectations of either full repayment or a steady income and are usually much more prone to market volatility.

Bond returns tend to move in the opposite direction to shares and play a valuable role in protecting near-term downside risk when the share market performs worse than expected over short periods. In other words, they typically act as a buffer to volatility in shares.

The problem is, last year was highly abnormal. Sharply deteriorating global economic conditions, largely thanks to surging inflations levels, caused extreme volatility on share markets and bond markets. Share prices and bond trading prices both fell.

However, just-released Australian Securities Exchange data shows $747m was invested into Australian bond ETFs in the three months to December 31 alone – almost as much as the amount of money invested into Australian shares ETFs ($816m).

This followed inflows of $920m into Australian bond ETFs in the third quarter, which actually exceeded the amount invested into share ETFs ($805m).

That’s extremely unusual. Bond inflows in Australia hardly ever exceed inflows into shares.

Over the course of 2022, total investment inflows into Australian bond ETFs rose 65 per cent from the year before to $2.8bn.

Investments into global bond ETFs listed on the ASX also surged in the final quarter of 2022, from just $50m of inflows in the third quarter to $492m over the final three months.

So, what’s behind the big bonds inflows?

The surging inflows into bonds largely comes down to two key factors: rising interest rates and investment portfolio rebalancing.

Interest rates had been hovering at record lows. But as central banks around the world moved quickly to raise official interest rates last year in a bid to curb inflation, investors began turning back to bond funds.

As official interest rates rise, so do the interest rate returns offered on new bond issues. That obviously makes bonds more attractive to investors seeking higher steady income streams.

The higher income payments now available from bonds is expected over time to offset the bond price declines that occurred in 2022.

In 2023, Vanguard’s return expectations for fixed income have significantly increased compared to a year ago.

Thanks to higher starting interest rates as a result of central banks around the world working to quell persistent inflation, we forecast global bonds to return 3.9-4.9 per cent and domestic bonds to return 3.7-4.7 per cent over the next decade – a 2 percentage point increase.

The increased demand for fixed income ETFs that we saw over the last half of 2022 is expected to grow as this new year unfolds.

The other key facet to the bonds boost is portfolio rebalancing.

The unusual correlation we saw between bonds and equities in 2022 – with both experiencing heavy price falls – is likely to end this year, delivering greater diversification benefits to investors holding both shares and bonds in their portfolios.

The normal role of bonds in investment portfolios is to provide asset class diversification to help smooth out total investment returns over time.

More and more investors are taking advantage of the higher returns now on offer from bonds to balance out their holdings in shares.

While bonds do not generally outperform riskier asset classes such as shares over the long run, they have a more stable return profile.

On this note, there was a lot of commentary last year about the death of the 60/40 portfolio. This year will likely to see a flip in sentiment, with a resurgence of this asset allocation approach as bond returns turn positive.

History has proven the worth of balanced portfolios, no matter the market conditions.

The key takeaway for investors here is that sticking with a diversified asset allocation and avoiding the urge to time the market is the best way to achieve long-term investment success, no matter which asset class is predicted to outperform.

Tony Kaye is a senior personal finance writer at Vanguard Australia

www.vanguard.com.au