As temperatures start to drop our clothing requirements change and we look for an extra layer to provide warmth and protection. While that puffer jacket may not be the most exciting item in our closet, it can be the one that provides the most comfort and protection.

The equity cycle

Similar to the change in seasons, growth assets such as equities follow a cycle.

In the good times, equities investors generally enjoy increasing prices and dividends. However, summer, the good times, comes to an end, and so begins the onset of winter.  Winter represents decreasing prices and potentially lower dividends. Unlike the seasons, the timing of changes in the cycle is far less predictable so it is good to consider whether you are prepared for a downturn.

Like a good insulated overcoat, bonds can mitigate the effects of the cold, a downturn in the market. The bonds that are used by many investors to mitigate the effects of a market downturn include Australian Government bonds and those issued by quality companies.

Some investors may be tempted by the more ‘fashionable’ version, the junk bonds or the suite of new income funds. But, it’s the inclusion of old fashioned, traditional bonds in a well-diversified investment portfolio that can offer much comfort.

More on the importance of investment grade bonds

Many Australian investors may be ‘exposed to the cold’

Surprisingly, a substantial number of Australian investors may be going without the appropriate protection, namely bonds, in their portfolio.  What is considered appropriate is dependent on an investors individual risk appetite, tolerance to losses and timeline for recovery.   How much risk are you prepared to take, how much of your portfolio are you prepared to lose and how long you have to recover from losses in your portfolio.

The typical institutional portfolio, based on a fund manager’s ‘balanced’ portfolio option, is well diversified across the major asset classes. The average SMSF portfolio shown in figure two has a similar exposure to shares and comparable exposure to property/infrastructure – but that’s where the similarities end. The fixed income exposure of SMSF investors is significantly smaller, and cash and term deposits substantially higher.

Institutional vs SMSF portfolio composition

Sources: Colonial First State Wholesale Balanced Fund 31 Dec 2018 & ATO SMSF statistics, Dec 2018

Australia – The global outlier for asset allocation

Among OECD countries, Australians are 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.

Source: OECD Pensions in Focus, 2018

Reliability of dividends vs coupons

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.

…What about more ‘fashionable’ fixed income investments?

Other investors may chase the higher return and opt for junk bonds and/or funds offering higher yields, but at what cost? Junk bonds are issued by companies that generally have a low credit rating and a higher risk of default. As a result, the bonds need to provide a higher yield to compensate investors for the greater risk associated with the investment.

Make sure sure you’re looking at defensive assets

If the 3-year risk free rate (Australian Government bonds) is currently 1.15%¹ and a ‘fixed-income’ product is offering 7% plus return, investors must consider what are the risks involved with that product? Do you really know what investments are included in an income fund and will the types of investment stay the same? If an income fund is offering returns above junk bonds, are you really investing in a defensive asset?

While these more ‘fashionable’ products may be a suitable accessory for investors with the appropriate risk profile, they don’t offer fitting protection for the average investment portfolio which fixed income should.

^{1 Bloomberg 24 May 2019}

How bonds offer protection

A known & regular 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.

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.

Diversification of returns

Bonds are classified as a defensive asset, with a different risk and return profile to shares; it’s this difference that provides the diversification benefit. While the prices of bonds will fluctuate according to interest rates and the economic cycle, historically bond prices have not been as volatile as share prices. 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.

^{Bloomberg & XTB May 2019}

Worst year for shares was 2008 -38%

Worst year for bonds was 1994 -5%

If you buy a good quality bond and hold it to maturity, the principal is repaid, and income (coupon) is paid for the duration of the investment term. All XTBs are currently over bonds from investment-grade issuers. Therefore, they can offer that much needed protective layer to your investment portfolio.

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.