Why investing in bonds is beneficial...
Fixed interest is a commonly misunderstood asset class.
The recent Global Financial Crisis (GFC) was a tough lesson for the uninformed investor as their "defensive ", fixed interest investments incurred significant volatility and access to some funds were frozen. With a prudent investment philosophy, and when utilised correctly, this asset class can be a key element in any diversified portfolio.
What is fixed interest?
Fixed interest investments, generally known as bonds, in their simplest form are essentially a loan made by an investor, to a "borrower" who may be the government, a company, or even a bank.
While there are many types of bonds, we'll focus on coupon paying bonds in this article
The loan is referred to as the face value of the bond. The interest rate is called the coupon rate and is used to determine the coupon payments, or interest payments receivable during the term of the loan. This is set when the bond is issued with reference to the current market interest rate curve and the term (time) to maturity. On maturity of the loan, the face value (initial loan amount) is then paid back. Bonds can be for short periods such as 30 days, 1 year or they can be for much longer like 10 years.
Companies use bonds as a method of sourcing new funds rather than issuing additional shares or going to banks for a loan. For companies it can be a more effective way of borrowing and can help maximise their balance sheet.
Governments use bonds as a way of getting capital to fund infrastructure and other projects. Banks use bonds as a way of raising funds rather than term deposits or savings accounts. Some bonds are also sold as having "bank acceptance" which means that they have an Australian bank guarantee.
Bond investors are generally considered secured debt holders, should the borrower be a corporate, and therefore rank ahead of a shareholder in the event of insolvency. As such, an investment bond behaves quite differently to shares, given the principles of risk/return.
There are two main risks when investing in bonds – term (time) risk and credit risk.
Term risk refers to the time until the maturity date of the
bond. Generally, the longer the term the higher the rate of return
as the investor must be compensated for taking on the risk that
interest rates will change over time.
Credit risk refers to the creditworthiness of the borrower and this tends to be rated such as AAA (a government bond would fall into this category) or BBB (a mining corporation may fall into this category).
It is also known as default risk and helps the investor to assess the risk of their investment not being returned.
When should bonds be included in a portfolio?
Bonds behave very differently to shares. When the stock market
is volatile and returns are negative, bond returns tend to be
positive and much more stable, given their defensive nature.
Investors who have high allocations to shares in their portfolio
can benefit significantly from some bond exposure.
This can be seen in the following chart:
Generally bonds are liquid which means you can access your funds easily. The bond market works just like the stock market in that there is a central exchange where all bonds are listed, bought and sold.
This, along with the regular coupon payments receivable makes bonds an ideal investment for meeting liquidity requirements and income payments for those in pension phase. Another reason investors chose to allocate some funds to bonds is that they pay a premium over the cash rate.
So for taking on some additional risk you will be compensated with a higher return. Investors who have an allocation to defensive assets may benefit by diversifying and splitting their allocation between cash and bonds. If you are still a little sceptical, just take a look at the asset breakdown of any balanced fund – they will be holding some exposure to bonds.
How is it different to a term deposit?
The characteristics of a bond are quite different to a term deposit. Unlike a bond investment, there is no potential for capital gains in a term deposit. Further, should investors require liquidity prior to maturity and break their term deposit the interest is generally paid back to the bank. Given bonds can be sold in the secondary market before maturity, just like a share, they are very liquid.
In periods of high volatility it is so important to diversify
asset classes. Greater diversification can be achieved by adding
bonds into a portfolio. Investors can gain exposure to government,
corporate, international and domestic bonds for as little as
The additional diversification will also ensure higher risk adjusted returns are received than would otherwise have been experienced without the bond exposure. Finally, bank deposit rates have not and may not always be this high, especially after fees and taxation.
Lessons learnt during the GFC
Prior to the GFC many structured products and managed funds were being presented as low risk, fixed interest or even income funds. Whilst some of these investments had bond like characteristics it highlighted the importance of investigating the underlying asset. Hybrid bonds such as mortgage backed securities or junk bonds are very different to government bonds and many investors were unaware of the additional risks.
The introduction of fixed interest exposure as a component of your investment strategy can reduce volatility, increase diversification and result in a higher return over time. Contact your adviser from Moore Stephens Wealth Management for a strategy that would suit your circumstances, needs and objectives.
This publication is issued by Moore Stephens Australia Pty Limited ACN 062 181 846 (Moore Stephens Australia) exclusively for the general information of clients and staff of Moore Stephens Australia and the clients and staff of all affiliated independent accounting firms (and their related service entities) licensed to operate under the name Moore Stephens within Australia (Australian Member). The material contained in this publication is in the nature of general comment and information only and is not advice. The material should not be relied upon. Moore Stephens Australia, any Australian Member, any related entity of those persons, or any of their officers employees or representatives, will not be liable for any loss or damage arising out of or in connection with the material contained in this publication. Copyright © 2011 Moore Stephens Australia Pty Limited. All rights reserved.