The place for bonds in your portfolio

Photo of Philip Bayley By Philip Bayley

min read

Any investment text will tell you that bonds are an essential asset class in a balanced portfolio. Bonds add negatively correlated diversity and reduce the volatility of the returns generated by the portfolio, or so the theory goes.

There is theory and then there is practice, and practice will not always produce the results predicted by theory. Moreover, from a traditional portfolio construction perspective, investors have quite a bit of discretion over how far their practice diverges from theory.

A simple explanation of what is meant by this: theory considers a portfolio invested in just two asset classes. Investors can hold risky equities (company shares) and risk-free assets (government bonds, but only risk-free if denominated in the currency of the country concerned).

Not surprisingly, the characteristics of the assets in this portfolio are consistent with the characteristics of such assets found in the American market. The shares will pay little or no dividends and will be held for expected capital growth, and the bonds will pay regular fixed-rate coupons.

Thus the shares will allow the capital value of the portfolio to grow, while the bonds will generate income to meet an investor’s recurrent expenditure or other income needs. This is good while economic conditions remain stable.

In addition, bonds can provide a portfolio with a cushion or buffer when economic conditions are not stable. The capital value of bonds that pay a fixed coupon will move up and down as market interest rates change.
If economic growth is strong, it could well be inflationary and the central bank will raise market interest rates to curb economic growth and offset inflationary risks. If market interest rates rise, then the capital value of a fixed-coupon bond will fall because the value of the fixed coupon paid is below current market expectations.

Thus, in a strongly growing economy the value of the shares held in the portfolio should increase, but the capital value of the bonds in the portfolio will offset this to the extent that the capital value falls.

Consider the long term
In this situation, it is tempting to consider not holding bonds. But in a long-term investment portfolio, as all portfolios should be, the value of bonds as something more than a source of income becomes apparent when the economy turns down.

In a downturn, the central bank will cut interest rates to stimulate economic growth. Share prices will be falling but the capital value of the bonds will increase as market interest rates fall below the value of the coupon paid.

Thus, an appropriate allocation to bonds can maximise returns while minimising the overall risk of the portfolio. The trick is to work out the appropriate proportional allocations to shares and bonds.

Leaving aside proportional asset allocation, retail investors in Australia can put theory into practice. They can construct a portfolio that contains shares listed on ASX, and to the extent that Australian companies tend to pay larger dividends than US companies, so much the better, the shares should not exhibit the same price volatility.

Australian investors can also add fixed-coupon, Australian government bonds (the risk-free assets) to their portfolios, as these too are listed on ASX. They will have the same performance characteristics expected in the theoretical investment portfolio.

However, in the post-GFC world of historically low interest rates, government bond yields do not look very attractive, ranging at the time of writing from zero to 3.57 per cent per annum for bonds with terms to maturity ranging from 2016 to 2037.

To boost returns, retail investors can look at bonds issued by Australian companies that are listed on ASX. But that will introduce two forms of risk not yet considered: interest rate risk and credit risk.

Virtually all debt securities listed on ASX pay floating-rate coupons rather than fixed-rate. This is a key difference because the cushioning effect of changes in the capital value of bonds, as market interest rates move up and down, is lost. (The term debt securities is used rather than bonds for the riskier debt issued by companies. This is simply to differentiate from government bonds.)

Floating-rate coupons move up and down with market rates and capital value will remain stable, all else being equal. Thus, when rates rise investors can expect to earn more income, but less when rates fall. Just like with bank term deposits.

Company credit risk
The lower the credit quality of the company issuing the debt securities, the higher the coupon rate that should be paid at issue, to compensate for the inherent credit risk.

Greater compensation will be demanded by the market if an issuer’s credit quality declines while its debt securities remain outstanding; the capital value of the securities can be expected to fall – just as a company’s shares will fall if its earnings outlook deteriorates.

The key difference, though, is where you rank in the capital structure of the company, which will determine the expected loss on your investment should the issuer default.

If the issuer defaults and is eventually wound up, shareholders can expect to be wiped out but the holders of senior-ranking debt may be repaid in full. Holders of subordinated debt and deeply subordinated hybrid notes may suffer varying degrees of capital loss.

The further down an investor ranks in the capital structure, the more equity-like their investment becomes and the portfolio benefits of holding bonds/debt securities will be steadily eroded.

Furthermore, as a debt security moves closer to equity, more equity-like characteristics will emerge, such as the flexibility to suspend coupon payments. These may be cumulative and eventually paid, or non-cumulative and simply lost.

Performance indices
We can look at credit risks through the performance of ASX-listed debt securities indices compiled by Australia Ratings. They are accumulation indices and therefore take into account income from coupons paid, as well as changes in the capital value of the debt securities.

The indices have been compiled from the end of February this year, with a base of 100. At the end of October, the value of the hybrid debt securities index had fallen to 95.47, a total negative return to investors of more than 4.5 per cent over the period.

The subordinated debt securities index stood at 100.56, after having moved below 100 in September. Investors have earned very little over the period. However, senior debt securities have had a positive return of 4.94 per cent as their index rose to 104.94.

Thus, as risk aversion increased over the year, returns to debt securities investors varied accordingly.

Compare this to returns to shareholders over the same period. The S&P/ASX 200 index stood at 5929 points at the end of February and finished October at 5239 points, a loss of 11.6 per cent excluding dividends.

Returns to debt securities have varied with changes in the credit quality of individual companies – Crown Resorts, Origin Energy and Woolworths come to mind – an overall increase in risk aversion over the period hit securities lower in a company’s capital structure the hardest.    

Under the ASX debt and hybrid research scheme, Australia Ratings has been engaged to rate listed debt securities. These ratings combine two very useful assessments for investors.

The first component of a rating is an assessment of the credit risk of the issuer and takes the traditional form of a credit rating ranging from AAA, in the case of the Commonwealth Government, to BB for issuers of intermediate risk.

The second component is a Product Complexity Indicator (PCI), which is colour coded to reflect where a debt security ranks in the capital structure of an issuer and the complexity of the terms and conditions that come with that.

A full list of the credit ratings and PCIs assigned by Australia Ratings to ASX-listed debt securities can be found at

About the author

Dr Philip Bayley is a director of Australia Ratings and the principal of debt capital markets consultancy, ADCM Services.

From ASX

Bonds provides information on the features, benefits and risks of various debt securities.

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