Investing

Australia – The Global Outlier for Asset Allocation

  • 22.Nov.2019
  • Richard Murphy,  XTB

The Australian anomaly of bond allocation

Although the stock market often commands more media attention, Australia also has a thriving bond market. However, it has largely been the domain of professional investors. Most corporate bonds are only available in $500,000 parcels, which historically has excluded most average investors from participating in this market.

Among OECD countries, Australians are actually second from bottom of the pile above only Poland in terms of portfolio allocation to bonds. Every single other OECD country has a more balanced allocation between shares and bonds. The average bond allocation across all OECD countries is almost 45%, yet Australia’s allocation is only one third of this, at 14.6%. ATO data for SMSF asset allocation is even more concerning with just 3.4% allocated to bonds.

Sample OECD: Pension Fund Asset Allocation in Bonds

Selection of OECD Countries allocations to bonds

Not all OECD countries are included in this chart.
Source: OECD Pensions in Focus 2019.

What are bonds?

Bonds have similar characteristics to interest-only loans, but with a role reversal between the ‘banker’ and the ‘investor’. Bond investors become the ‘banker’ and the bond issuer repays the principal at maturity and makes coupon payments during the life of the bond (subject to no default).

They are known as ‘fixed-income’ securities because the amount of income they generate each year is ‘fixed’ when the bond is issued. Fixed-rate bonds will receive the same income payment for the life of the bond, no matter who holds it. Floating Rate Notes pay a fixed margin above a reference rate, for example a margin above BBSW, no matter where the reference rate is set.

The trilogy of bond features

1.      Income stream

Bonds provide income from regular quarterly or half-yearly coupon payments, paid on set dates. This feature allows investors to choose specific bonds with coupon dates aligned to known outgoings.

Bonds also have fixed maturity dates when the principal amount or face value is repaid. Bond investors know when they will receive the face value of the bond back to either spend, or re-invest. Not many other investments allow for forward planning with such accuracy.

2.      Capital preservation

Bonds can provide capital stability. At maturity the bond face value is returned to the investor. This makes a bond an effective capital preservation tool – assuming the issuer doesn’t default.

3.      Diversification of returns

Bonds usually have low or negative correlations to equities, and have a different risk/return profile.  We know all investments carry risks, but as the potential upside of shares is higher than bonds, the same is true of the potential downside.

Worst Year for Shares vs Worst Year for Bonds

Source: Bloomberg returns for shares and bonds from 1994 to 2019.
Shares -38% in 2008, bonds -5% in 1994

Portfolio protection in uncertain times

Investment-grade bonds are a defensive asset class. They offer stability and diversification in a portfolio. 2018 was a bumpy year for shares, but so far 2019 has seen shares rebound. The question is where to from here?

When the share market seems to be going up and up, it’s easy to overlook the cushioning effect of a solid fixed income foundation. But, in volatile times it’s increasingly important to ensure you protect the wealth you’ve built up.

Investors with balanced portfolios (50:50 bonds and shares), may find that in times of equity market stress, their bond returns can balance their losses.

Shares and bonds are complementary and necessary parts of a well-diversified portfolio

Total Returns Equities vs Bonds: 1 Jan 2018 to 30 Sep 2019

Chart of equities vs bond performance

Source: Bloomberg & XTB

Bond coupons are fixed, share dividends are not

AMP, BHP and Telstra made cuts (and some hikes) to dividend payments over the last year or so. No one complains when a dividend is hiked, but cuts are harder to swallow. Dividends are paid at the discretion of the company, and are declared shortly before payment. In contrast, bond coupon payments are a legal obligation, decided when the bond is issued.

“I want to be the banker now, rather than the shareholder. It’s a much safer way to invest – I don’t have to worry about share price volatility anymore.” 

Read the full XTB retired investor case study

Is there a correct ratio of shares to bonds?

This is a personal decision for each investor, but it shouldn’t be a one-off decision. The ratio between fixed income and growth assets – or the split between shares and bonds – should change as you age.

There’s a simple rule of thumb, coined by the late John Bogle, founder of Vanguard that your bond allocation should roughly equal your age. Clearly not an exact science, but it demonstrates the increasing need for fixed income as we move through life.

What risks should you be aware of?

As with all investments, there are risks. It’s important to remember that with higher yield comes higher risk, whichever asset class you are looking at. Much of the risk from owning bonds is driven by two factors:

1.       Time to maturity and

2.       Credit quality of the issuer.

By focusing on investment-grade issuers, the potential of a default can be minimised.  The global default rate for 3-year Investment Grade bonds is 0.43%, but jumps to over 10% for speculative grade bonds.

While it is rare for an ASX100 company to go into liquidation, it is not unheard of. A large company, with significant assets and a strong business model is more likely to be able to make coupon payments and repay the bond’s face value upon maturity.

If the bond you’re considering has five years to maturity, you should consider ‘will this company be in existence in five years?’

More on the risks of bonds and XTBs

Choices for bond returns on ASX

A broad range of ETFs, mFunds and over 40 different Exchange-Traded Bond units (XTBs) provide access to bond returns on ASX.

Bond ETFs and funds provide investors with a very diverse range of bonds within one transaction. They’ve helped open up access to this asset class and offer a simple way to buy and sell via ASX. But, there is a key consideration for investors.

The ‘fixed income’ gets lost in bond funds and ETFs

Bond funds and ETFs are continual – there’s no end date and therefore they can’t provide a predictable return BEFORE you invest. And, being pooled products, new bonds are added or removed, sometimes on a daily basis, with potentially hundreds of bonds included. That’s good for diversification, but it means investors don’t know what their income or return will be.

Knowing your cash flow BEFORE you invest is at the heart of fixed income.

 

Keeping the predictability in your ‘fixed income’

XTBs (Exchange Traded Bond units) differ to ETFs and funds. Rather than being diversified, continual investments, each XTB ‘mirrors’ a single, specific bond issued by one company.

So, each XTB provides two known features:

1.  A Coupon Amount and Payment Schedule and

2.  A Maturity Date.

If you currently have little or no exposure to bonds, and simply want a broad exposure to fixed income, take a look at the range of ETFs or mFunds available.

However, if you want the predictability of known income dates, known maturity dates and a known return before you invest, XTBs could be a better fit.

For those with an existing bond ETF, adding one or two XTBs could provide a complementary element of predictability.

Download our eBook to find out more.

1 ATO SMSF data June 2019

Source: OECD Pension Market In Focus 2019

This article was first published in ASX Investor Update: View here
Disclaimer
The information in this article is general in nature. It should not be the sole source of information. It does not take into account the investment objectives or circumstances of any particular investor. You should read the PDS that relates to that Class of XTB prior to making an investment decision and consider, with or without advice from a professional adviser, whether an investment is appropriate to your circumstances. Australian Corporate Bond Company Limited is the Securities Manager of XTBs and will earn fees in connection with an investment in XTBs.

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Events

  • 11Dec 2019

    YTMQF2: QANTAS 7.50% 11 JUN 2021

    This is the coupon date

  • 16Dec 2019

    YTMNA1: NAB 4.00% 16 DEC 2021

    This is the coupon date

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