Bonds are an often neglected investment. One which should be at the centre of a well-diversified portfolio. Like the iconic Australian clothing brand of the same name, bonds provide a reliable foundation – not of one’s wardrobe but of one’s portfolio.
American financial theorist Dr William Bernstein coined the phrase “Bonds are the underwear in your portfolio – unexciting and not much thought about, but select the wrong pair and you’ll be surprised at just how uncomfortable you are.”
Like a good foundation garment, bonds should be the boring but predictable base of every portfolio.
Some investors get tempted by the ‘sexier’ version, junk bonds or look beyond bonds to hybrids. But it’s old fashioned, traditional bonds that should be the foundation of a well-diversified portfolio.
Check if you’re ‘going commando’
Many Australian investors are currently ‘going commando’. They don’t have the appropriate foundation in their portfolio. Australia is a global anomaly – among OECD countries we are close to bottom in our allocation to bonds. Aside from Poland, every other country has a more balanced allocation between shares and bonds¹.
Term deposits alone do not make a good foundation…
For the past two years we’ve been stuck with a cash rate of just 1.5%. Most economists believe we still have two more years at this record low. A recent poll we conducted of financial advisers found that 75% stated 2020 as the earliest date for a rise. 25% of these thought it would be 2021 or even 2022 before we saw a rise. That’s still leaves almost 500 days before we can expect the cash rate to rise.
Yet investors continue to pour cash into savings accounts and term deposits. Recent APRA data showed we tipped over $900 billion on deposit for the first time.
…nor do ‘sexier’ fixed income or hybrid investments
Other investors may chase higher returns and opt for junk bonds or hybrid investments. These more flamboyant products may be suitable accessories for investors with the appropriate risk profile. They certainly don’t qualify as a fitting foundation for the average investment portfolio.
Why bonds make the best foundation garment
With good reason Dr Bernstein referred to bonds as the underwear – or foundation garment – of an investment portfolio. Bonds fulfill three important roles in an investment portfolio:
One: An income stream
Bonds provide income from regular coupon payments. These are generally quarterly or half-yearly on set dates. As a result, investors can accurately plan to match outgoings with this known income. Most other investments don’t enable forward planning with such accuracy.
Two: Capital preservation
Bonds can provide capital stability. At maturity a bond’s face value is returned to the investor. This makes a bond an effective capital preservation tool – assuming of course that the issuer doesn’t default.
Three: Diversification of returns
As a defensive asset, bonds are low or negatively correlated to equities, and have a different risk/return profile. It’s this difference that provides the diversification benefit. Bond prices may fluctuate according to interest rates and the economic cycle, yet historically they have been considerably less volatile than share prices.
- Annualised Equity Volatility: 15.0%
- Annualised Bond Volatility: 2.3%
While investors can reap some of these benefits from a bond fund or ETF, a direct investment in bonds really makes the most of a bond’s unique features. Previously, direct investment in bonds has been challenging. XTBs – exchange traded bond units, traded on ASX – can make them more accessible.
But remember, bonds come in many shapes and sizes
We’ve seen that bonds can offer diversity to your portfolio. Investment grade corporate bonds can deliver attractive income yields across the economic cycle. They can complement your portfolio by lowering volatility.
But what are some key considerations before investing in a bond or XTB?
Five steps to evaluate corporate bond issuers
Irrespective of the low probability of ASX100 companies defaulting, it’s always good practice to understand the company central to your investment, whether you’re an equity or bond investor.
Is the company likely to be around for the term of your bond?
While it is rare for an ASX100 company to go into liquidation, it is not unheard of. A large company, with significant assets, a strong business model and competitive advantages is more likely to last the distance. They are more likely to be able to make regular interest or coupon payments and repay the bond’s face value upon maturity. If the bond you’re considering has five years to maturity, you should be considering ‘will this company be in existence in five years?’
Do you understand where the bond sits in the capital structure?
The capital ranking of securities indicates the order of when you get paid back, relative to other creditors. It also indicates price stability – higher ranking investments tend to be less volatile than lower ranking investments. Corporate bond prices and yields are generally far less volatile than securities ranked below them in the capital structure.
In the event of a company going into liquidation, equity investors are first to lose their money. They are followed by investors in hybrids and subordinated debt. Investors in these securities must be wiped out before bondholders incur a loss.
Has the company previously issued bonds? Have all payments of interest and face value been met?
Australian companies issuing bonds are legally required to make all payments to the bondholder as set out in the bond documents. Although there is always a first time, a history of default sounds warning bells. XTB’s focus on Australia’s 100 largest companies, which considerably reduces this risk.
What is the business environment like for the company? Does it face competitive pressures, regulatory change, geopolitical or macro-economic risk?
Factors that impact a company’s financial performance or influence its business strategies can affect its cashflow and profitability. It’s important to understand the business risks that could impact a company’s ability to service its debt.
Does the company have good credit? Does it meet its liabilities on time?
A company’s financial statements can provide a wealth of information about the business. Cashflow, profitability and liquidity. A profitable company that consistently generates positive cashflow generally has a good financial position from which to service its debts. That includes interest payments and repayment of principal. That, of course, is what every bond investor wants!
Bonds help you sleep at night
Bonds are not exciting. Bond investors generally don’t experience the crazy highs shares can deliver. But neither do they experience the sweat-inducing panic of a share market rout. While it’s possible for a bond market crash, investors generally lose money only when they sell, before maturity.
You can further minimise the risk of bonds by holding ‘good quality’ bonds – such as those from top ASX companies via an XTB. If you hold to maturity, the face value is repaid, and income (coupon) is paid for the duration of the investment term. Boring maybe, but a great foundation for any investment portfolio.
This article first appeared in ASX Investor Update, October 2018