As interest rates continue to fall in Australia, investors may want to take their cue from the Reserve Bank of Australia (RBA).

At the time of its monetary policy meeting in early May, the RBA surely knew that fiscal stimulus was not going to be a key component of the budget to be released just a few hours later. As a result, the RBA, like many other central banks around the world, played the hand it was dealt and provided monetary stimulus to offset the lack of productive fiscal and structural support. Many commentators were critical of the RBA’s decision to lower the policy rate, but we believe it was the correct one. Australia’s economy has experienced what we would refer to as an “unbalanced rebalancing” from mining to housing, and without some sort of policy support, the Australian economy is vulnerable to a slowdown.

Like the RBA, investors may find that facing up to reality leads to much better decisions. Rather than invest for better days ahead, investors should position their portfolios in line with the fundamental economic backdrop today, the current valuation of assets and very importantly, the policy settings that are most likely to occur ‒ not what they think should occur.

The reality is with the Australian policy rate now at 1.75%, we have started a new chapter of the New Neutral for Australia, and this has implications for Australian investors. First, the hurdle to invest in assets, rather than sit on cash, has been lowered, again. Second, stable sources of real income are becoming more difficult to find. Finally, portfolio diversification is becoming even more important in the low-return environment as there is less of a “cushion” to absorb losses.

These implications suggest a return to the fundamentals of investing, which are sometimes forgotten even within the bond asset class. Why do investors buy bonds in the first place? For capital security, for income generation and for diversification. Implicit is the need to have some exposure to interest rates, or duration, as part of an overall portfolio allocation. Australian portfolios in general are already underweight interest rate exposure, so staying true-to-label and benchmark-aware in a core bond portfolio should be a prerequisite. Yet, many investors take structurally lower duration positions in their core bond portfolios. This comes with its own risks, including diminished down-side protection in market sell-offs and locking in a structurally lower level of overall carry.

The correlation between the Australian duration risk factor and the Australian equity risk factor actually has become increasingly negative over the past six months, based on analysis by PIMCO client analytics specialist Laura Ryan. This means equity-heavy portfolios are less volatile when investors include bonds in the mix, despite the low level of Australian interest rates.

Takeaways

Investors, especially those approaching or in retirement, may benefit from playing the hand they have been dealt in key ways: 1) acknowledge that expected returns will be lower and that chasing higher returns equals taking much higher risk; 2) take advantage of the effective ways to generate relatively capital-stable real income and consider investing in  bonds; 3) diversify across asset classes to help reduce portfolio volatility, which, in our view, will be critical in the coming investment environment.

Robert Mead is a managing director in PIMCO's Sydney office and head of portfolio management in Australia.