The Australian sharemarket had a strong year compared to the negative returns recorded by most offshore markets and reflects the comparative resilience of the Australian economy throughout the calendar year. While the global economy contracted, the strength of dwellings, construction activity, reasonable retail sales in conjunction with the stimulatory impact of the weak Australian dollar helped cushion the Australian economy and corporate earnings.
Ownership of public bonds is both fluid and dispersed. Fluidity and dispersion generate benefits: They increase the liquidity of public bonds and make their risk more easily diversifiable. By the same token, however, fluidity generates a bonding problem and dispersion generates a collective action problem. In the context of public bonds, these problems increase the agency cost of debt and thus lower the overall value of the company. Private debt, the ownership of which is neither fluid nor dispersed, lacks easy diversification and liquidity, but also entails lower agency cost of debt.
Since 1997, the Australian central bank has been attempting to mimic U.S. interest rate policy, while doing nothing to effectively staunch the Aussie’ s decline. Historically, investors in Australian bonds demanded a premium to U.S. rates as compensation for greater perceived currency risk. In 1991 Australian 1-year rates were over 10%, while US rates were 6%. In 1994, Australian rates were 10% versus 7% in the U.S., and in 1996, rates were 8% versus 6% in the U.S. From 1990 to 1997, Australian bonds typically offered about a 2% higher yield than U.S. bonds.( http://capmag.com/article.asp?ID=417)
Macquarie’s Global Bond Solution, a fund-of-funds which includes six fixed interest sectors and five specialist managers, has posted an after fee return of 11.8% for the 12 months to end December, compared with a return of 3.0% in Australian bonds.
Macquarie Funds Management Associate Director Louise Walker said Macquarie was particularly pleased with the returns during the past three years because it had achieved this result with a level of risk similar to that of Australian fixed interest.
There are a number of different factors that could affect the performance of the secondary market for bonds such as
Time to maturity
Supply and demand
Relative value to other assets
To make the bond attractive to investors the issuer has to take the level of interest rates and inflation into consideration. The issuer will try and give a real return that will stay ahead of the projected level of interest rates during the term of the bond. Fluctuations in interest rates will cause volatility in the bond market. Rising rates are bad for bonds; falling rates are good for bonds.
Unlike the secondary market of Treasury securities (one of the most liquid markets in the world), the secondary market for corporate bonds is not as liquid; only a fraction of corporate bonds outstanding trade regularly at an organized exchange. The return that bonds provide investors is usually based on interest and principal payments. Bond prices rise and fall inversely to their yield, which is a function of a bond’s price and interest rate. A bond issued with a 5 percent yield will drop in price if market conditions require a higher yield. If market interest rates fall below 5 percent, the price of the bond will rise to bring the yield, once again, in line with the market.
First, with varied maturities, yields and other structural features, bonds are far less homogeneous than stocks. Consequently, it would be impossible for a single dealer—or even all dealers combined to be able to make continuous price quotes in all outstanding debt securities. This is made even more difficult by the fact that the number of bonds is orders of magnitude greater than the number of stocks. The same company whose stock is available for purchase by the public might also have issued dozens or hundreds of separate bonds each with a unique set of features.
States, municipalities and other political subdivisions issue general obligation bonds, which-although backed by the issuer’s full faith and credit-have an increased level of default risk. Municipalities also issue revenue bonds, which are serviced by income from specific revenue-producing projects such as toll bridges. Revenue bonds often carry a higher risk than general obligation bonds since their repayment depends on the project’s success. Interest received on municipal bonds is free of federal income tax.
Immunization should be used cautiously. If interest rates are expected to increase, the return on the investment is higher using a maturity strategy than using a duration strategy. This can be seen by comparing exhibits 5 and 6 at 14%. At that rate, the bond investment’s future value is greater using the maturity strategy than using the duration strategy. When the maturity strategy is used during periods of rising interest rates, the increase in interest reinvestment earnings is not offset by a decreased amount received at the investment horizon’s end. Instead, bond principal is recouped by collecting the par value from the issuing company. The opposite is true during periods of decreasing interest rates.
Predicting interest rate movements over an extended period is very difficult; therefore, the investor’s risk attitudes should be considered when choosing a strategy. A conservative investor should use the duration strategy even if interest rates are expected to increase. On the other hand, an investor willing to accept more risk might use the maturity strategy if rates are expected to increase.
Nongovernment entities also issue bonds (debentures). These bonds’ default risk depends on the issuer’s ability to service the debt, which in turn depends on the issuer’s financial condition and the business risks it faces. Default risk can be lowered by adding covenants to the bond indenture. Covenants provide safeguards to bondholders by restricting business activities.
There are two elements of investment risk: systematic (nondiversifiable) and unsystematic (diversifiable). Unsystematic risk is firm specific or diversifiable. Systematic risk is inherent in the market and therefore cannot be diversified. Examples of diversifiable risks are events such as lawsuits, strikes and unsuccessful marketing programs. These risks are specific to a particular company or firm, and thus by investing in multiple firms, investors can reduce risk. Market risk, on the other hand, is nondiversifiable. A few examples include inflation, recession and high interest rates, which have an impact on all firms and hence cannot be eliminated through diversification.
In order to identify diversification opportunities, one must examine the correlation coefficients. A correlation coefficient measures the degree of co-movement between two securities. A positive correlation indicates that the securities move together on average over time, and a negative correlation indicates movement in the opposite direction. When two securities are perfectly negatively correlated, all unsystematic risk can be diversified away, but since co-movement is not perfectly correlated, there is an opportunity for risk reduction.
strategy of investing that does not take into account the correlation coefficients is considered to be naive diversification. This idea is founded on the premise of efficient markets and is acceptable as long as investors are able to freely move their capital between the investment opportunities.
The primary motive in holding a diversified portfolio of securities is to reduce risk. The total risk of the portfolio will depend not only on the number of securities in the portfolio, but also on the risk of each individual security and the degree to which these risks are interdependent of each other. Diversification benefits will be improved if a portfolio consists of assets held in many different industries and across geographic boundaries. Thus, although diversifying in different stocks seems to be a wise thing to do, there is also a strong case for including real estate in order to reduce risk even further.
In addition to the correlation between assets, investors can consider the correlation within real estate as an asset class, like geographical differences and asset-type differences. For example, there is certainly a difference between office buildings and residential real estate.
Another area that deserves separate attention is research concerning the decision to diversify across national boundaries. This requires the investor to place assets abroad directly. Indeed, as financial markets rapidly globalize and become increasingly integrated, international diversification becomes more attractive to institutional investors due to the increasing ease of investment and access.
While conventional wisdom suggests that a dump-what’s-cold-to-buy-what’s-hot strategy is a poor idea, few investment experts argue against rebalancing, which typically involves trimming winners and putting the take into parts of a portfolio that have been lagging.
“People who practiced asset allocation with discipline during the last few years have been rewarded for it, while those people who made big bets and let their portfolio swing wound up hurting themselves,” says Mark Balasa of Balasa, Dinverno, Foltz & Hoffman in Schaumburg, Ill. “There’s a fine line between chasing performance and rebalancing, but people should be trying to walk it now.”
Rebalancing is best done infrequently. Some studies suggest that once every two years is sufficient. If a portfolio has moved 10 percent or more from its planned allocation, the time is right.
There is ample empirical evidence (Bailey and Stulz, 1990; Cumby and Glen, 1990; etc.) that internationally diversified portfolios provide a greater degree of diversification in comparison to domestically diversified portfolios. This greater reduction in risk usually is obtained because the movements in stock prices in different countries typically have correlation coefficients of less than one. These less than perfectly positive correlations between the returns of world stock markets allow an investor to increase expected rate of return for any given level of risk.
Several studies have attempted to evaluate the performance of international bond and/or common stock portfolios. In determining the performance of portfolios, problems arise as to which performance measure should be selected. Traditionally, performance has been evaluated using the two moment capital asset pricing model (CAPM). The selection of performance measures based on the two moment CAPM is subject to criticism, however, especially when the return distributions of portfolios are not symmetrical.
In light of the evidence on the greater integration of developed stock markets, portfolio managers should consider investing in non-developed markets. Indeed, parallel to the growing integration of the developed stock markets, a new phenomenon took place: the emergence of new financial centers in Asia (Hong Kong, India, Indonesia, Malaysia, Singapore, South Korea, Taiwan and Thailand) in the eighties, and in South America (Argentina, Brazil, Chile, Mexico and Venezuela) in the nineties. Today, these developing markets are generally referred to as “emerging markets”. Investing in developing markets is appealing because the benefits of international diversification into these markets can be substantial
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Geurts, Tom G., and Hilary Nolan. “Does Real Estate Have a Place in the Investment Portfolio of Tomorrow?.” Review of Business 18.4 (1997): 19+. Questia. 17 Oct. 2004
Jovanovic, Boyan, and Peter L. Rousseau. “Liquidity Effects in the Bond Market.” Economic Perspectives 25.4 (2001): 17+. Questia. 17 Oct. 2004 <http://www.questia.com/>.
“Time Is Now to Rebalance Portfolio.” The Washington Times 12 Aug. 2003: C08. Questia. 17 Oct. 2004