The share market kicked off 2016 with a bout of volatility, making investors think carefully about capital security, yield, and asset class diversification. What kind of role can corporate bonds play in a retirement income portfolio?
With TD rates tracking interest rates down to all-time lows and continued equity market volatility, there is a growing need for higher yielding fixed-income investments. As more Australians approach retirement, it’s particularly critical to consider ways to de-risk portfolios. Until now, SMSF members have been heavily reliant on term deposits for predictable, stable returns. However, for those looking for asset class diversification, regular income and capital stability, corporate bonds can provide better returns than term deposits¹ or other cash-based products.
SMSFs missing out on bonds
Despite the compelling opportunities corporate bonds present, they represent a very small proportion of Australian SMSF portfolios. Estimates from the ATO reveal that at September 2015, SMSFs held 30 per cent of fund assets in direct Australian shares, 27.1 per cent in cash and term deposits, and 13 per cent in direct Australian property. Bonds have typically accounted for less than 3 per cent of all SMSF assets.
This sets Australia’s super system apart from global peers. According to consultants Towers Watson, the entire Australian super system held about 16 per cent of its assets in bonds at the end of 2014. Across seven other international super systems that Towers Watson considered, the corresponding figure on average was 31 per cent.
A 2015 SMSF Association and nabtrade study of Australian SMSFs –Intimate with Self-Managed Superannuation – highlights SMSFs’ reliance on term deposits as a fixed-income solution, but indicates that many are interested in exploring their investment options outside of cash.
According to the report, close to half (42.9 per cent) of SMSFs now hold more than 10 per cent of their portfolio in cash, compared to 28.6 per cent in 2013. The main reason for this allocation was to reduce risk or because the trustee was ‘waiting for a better investment option’. Further, the report showed that there is significant interest in other investment opportunities, especially bonds. According to the report, 37 per cent of SMSFs were investigating other opportunities in fixed income, compared to just 18.5 per cent in 2013.
The advantages of corporate bonds are many
Corporate bonds can bring SMSF investors a number of advantages, with a key feature being capital stability. Corporate bonds are essentially loans by the investor to the company, and so unlike shares, they are assessed on the ability of the issuer to make the ongoing interest payments and to repay the bond investor at maturity. Although corporate bonds can lose value if the risk the issuer might default increases, the corporates that issue bonds in the wholesale market are generally investment grade and all of the XTBs (exchange-traded bond units) on ASX cover investment grade bonds. Corporate bonds and XTBs are significantly less volatile than the securities below them in the issuer’s capital structure, in particular shares and hybrids.
Additionally, true asset class diversification of portfolios across fixed income, equities and property is important for investors. As corporate bonds are generally negatively correlated to equities, fixed income investments, like corporate bonds, have an important role in a balanced portfolio.
The appeal of corporate bonds is also boosted by the fact that they generally offer higher yields than cash, term deposits of the same maturity and government bonds. This is because the bond holder is taking slightly more credit exposure to an ASX-listed company, such as Telstra or Wesfarmers, as opposed to a bank deposit. However, the question to ask is, what is the likelihood of Telstra or Wesfarmers not paying its bond holder’s interest payments? If you think this is low, then you can benefit from the higher returns corporate bonds offer over cash and term deposits, without the capital instability of shares or hybrids.
Before the introduction of XTBs in 2015, SMSFs were largely unable to access exposure to corporate bonds directly, due to the Australian corporate bond market trading in parcels of securities mostly only affordable to institutional investors, or very-high-net-worth investors.
The introduction of XTBs on ASX means that SMSF and retail investors can now gain direct exposure to the corporate bond market in Australia.
In short, corporate bonds are high quality and low volatility investments that may be suitable for risk-averse investors.
¹ Term Deposits may enjoy the benefit of protection under the Financial Claims Scheme