Outcome Based Investments
Bonds (or XTBs over them; we use the terms interchangeably) are outcome based investments. Absent of a company default, the cash flows you are going to receive are locked in. We discuss that the probability of default of an Investment Grade Bond within 1 year is 0.11% in this article. The same cannot be said for equities. You cannot guarantee a price of $100 on the 13th November 2018 for example, whereas you can with bonds.
When to buy an XTB?
If you are happy with the set of cash flows available by purchasing the XTB today at today’s price or YTM, then today is the right time to invest. The matter of ‘market timing’ is reduced because you are investing for an outcome.
Searching for a better outcome?
The next logical question is, ‘what if I wait a bit and potentially get a better outcome?’ There is merit to this, of course. Bond prices do have some daily fluctuations. However, when you crunch the numbers it becomes evident that the typical price movements most people are accustomed to with equities are extremely unlikely with XTBs.
What is the probability of that happening?
In general, people use “annualised volatility” to compare the daily price moves of asset prices. The ASX200 Accumulation Index had an average volatility of 18.2% over the last 10 years. By way of comparison, the Bloomberg AusBond Credit 0+ Yr Index had volatility of 1.9%. Both indices are used to describe the general underlying market, and we discuss the driving forces behind these different levels of volatility in this article.
This means that the probability of a 0.5% pull back in equity prices on any given day is ~33%, whereas for bonds it is ~0.002%. The likelihood of a 1% pull back over 20 days are 42% and 3.4% respectively.
Note: We use simplified mathematics for illustrative purposes only. In particular, these volatilities are of general indices and not a particular bond’s prices. Historical volatilities may not reflect future volatilities.
In short, the probability of ‘waiting for a pullback’ in bonds paying off is significantly reduced compared to equities.
The opportunity cost of time
XTBs are generally higher yielding than a Cash Account. Therefore, for every day you do not own an XTB, you miss out on that additional yield. This is perhaps best described with two examples.
- Say a 5-year XTB earns 3.25% p.a. and a Cash Account earns 0.80% p.a.
- Take an investor with a desire for a 0.75% p.a. rise in yields in XTBs before investing (i.e. the 5-year XTB at 4.00%).
- This means that every day the investor waits, they miss out on 2.45% p.a. aiming to gain an additional 0.75% p.a. for the life of the XTB.
- If the XTB yield takes longer than 1.17 years to rise to this level the investor is worse off in terms of total return.
Taking the volatilities we used before, the probability of this happening is ~10%. Again, we use simplified mathematics for illustrative purposes and stress that we have applied the volatility of the Bond Index to an individual bond which is sufficient for illustrative purposes only. The important point is that the perception of the probability of a ‘pull back’ is much lower than many would expect.
These numbers, whilst using simplified mathematics, are indicative of the potential outcomes for investors. What is made clear is that due to the much lower volatility in XTBs, traditional equity investors need to rethink their approach when considering likely market moves and therefore any potential better outcomes than current XTB prices over the life of the bond.
It takes a small retraining of the investment decision making process to look at “am I happy with that outcome” instead of “where do I think I can buy these?”. For many XTB investors it is the former mind frame which we encourage.