Why bonds should be a portfolio foundation

Photo of Richard Murphy, XTBs By Richard Murphy, XTBs

min read

Three important roles – and five steps to evaluate the issuers.

Bonds are often neglected as an investment, but should be at the centre of a well-diversified 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 is old-fashioned, traditional bonds that should be the foundation of a well-diversified portfolio.

Many Australian investors currently do not have this 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 bonds. (Source: Deloitte Corporate Bond Report 2018.)

Term deposits alone do not make a good foundation

For the past two years we have been stuck with a cash rate of just 1.5 per cent, and most economists believe we still have two more years at this record low.

A recent poll of financial advisers found 75 per cent believed 2020 was the earliest date for a rise in the cash rate, and 25 per cent of these thought it would be 2021 or 2022. That 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 Australian Prudential Regulation Authority (ARPA) data showed more than $900 billion on deposit for the first time.

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, but certainly do not qualify as a fitting foundation for the average investment portfolio.

Why bonds make the best foundation

Bonds fulfil three important roles in an investment portfolio:

1. An income stream
Bonds provide income from regular coupon payments, generally quarterly or half-yearly on set dates. Investors can accurately plan to match outgoings with this known income. Most other investments do not enable forward planning with such accuracy.

Source: XTBs

2. Capital preservation

Bonds can provide capital stability. At maturity a bond’s face value is returned to the investor, which makes it an effective capital preservation tool – assuming, of course, that the issuer does not default.

3. Diversification of returns

As a defensive asset, bonds are low or negatively correlated (linked) to equities and have a different risk/return profile. It is 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 per cent
  • Annualised bond volatility: 2.3 per cent

 

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 have 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 an ASX 100 company defaulting on its debt repayments, it is always good practice to understand the company central to your investment, whether you are an equity or bond investor.

1. Durability

Is the company likely to be around for the term of your bond?

While it is rare for an ASX 100 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 are considering has five years to maturity, you should be considering,” Will this company be in existence in five years?”

2. Capital structure

Do you understand where the bond sits in the capital structure?

Source: XTBs

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.

3. Track record

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.

4. Business risks

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 is important to understand the business risks that could impact a company’s ability to service its debt.

5. Credit risk

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 and bond investors generally do not experience the crazy highs shares can deliver. But neither do they experience the sweat-inducing panic of a sharemarket rout. While it is possible for a bond market to 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.

About the author

Richard Murphy is the CEO and one of the founders of Australian Corporate Bond Company, the company behind XTBs. XTBs make the benefits of high-quality corporate bonds accessible to everyone on ASX. There are more than 50 corporate bond XTBs available offering yields of up to 3.9 per cent (18 September 2018).

The range of XTBs is available here. The XTB Cash flow tool allows investors to check the return they will receive on an investment in XTBs.

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 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.

From ASX

To learn more about the features, benefits and risks of bonds quoted on ASX, and interest rate securities, take the free online ASX Bonds and Hybrids course

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

© Copyright 2018 ASX Limited ABN 98 008 624 691. All rights reserved 2018.
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