This article was first published in ASX Investor Update: View here
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 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 bottom of the pile in terms of portfolio allocation to bonds. Every single other OECD country has a more balanced allocation between shares and bonds. Globally, the seven countries with the largest pension funds allocate 29% to bonds, yet ATO data shows Australian SMSFs hold just 1% in bonds1.
Source: OECD Pensions in Focus 2018
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 2018. 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 31 Mar 2019
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.” Retired XTB investor
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.
“Your percentage of bonds should roughly equal your age.”
Risks to 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?’
Choices for 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’
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.
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