Bonds a cushion for a bumpy sharemarket

Photo of Richard Murphy, XTB By Richard Murphy, XTB

min read

Australians way below average worldwide allocation for bonds.

What are bonds? They have similar characteristics to interest-only loans, but with a role reversal between the “banker” and the “investor”. Investors become the banker, and the bond issuer repays the principal at maturity and makes coupon payments during the life of the bond (subject to no default).

Bonds are known as fixed-income securities because the amount of income they generate each year is fixed when the bond is issued. Fixed-rate bonds will receive the same income payment for the life of the bond, no matter who holds it. Floating-rate notes pay a fixed margin above a reference rate, for example a margin above the bank bill swap rate (BBSW) no matter where the reference rate is set.

The Australian anomaly of bond allocation

Although the stock exchange often commands more media attention, Australia also has a thriving bond market. However, it has largely been the domain of professional investors. Most corporate bonds are only available in $500,000 parcels, which historically has excluded most average investors from participating.

Among OECD countries, Australians are bottom of the pile in terms of portfolio allocation to bonds. Every other OECD country has a more balanced allocation between shares and bonds. Globally, the seven countries with the largest pension funds allocate 29 per cent to bonds, yet ATO data shows Australian Self-Managed Superannuation Funds hold just 1 per cent in bonds.


Source: OECD Pensions in Focus 2018

The trilogy of bond features

1. Income stream
Bonds provide income from regular quarterly or half-yearly coupon payments, paid on set dates. This allows investors to choose specific bonds with coupon dates aligned to known outgoings.

Bonds also have fixed maturity dates when the principal amount or face value is repaid. Investors know when they will receive the face value of the bond back to either spend or reinvest. Not many other investments enable forward planning with such accuracy.


 
2. Capital preservation
Bonds can provide capital stability. At maturity the face value is returned to the investor, which makes a bond an effective capital preservation tool (assuming the issuer does not default).

3. Diversification of returns
Bonds usually have low or negative correlations to equities and have a different risk/return profile. We know all investments carry risks, but as the potential upside of shares is higher than bonds, the same is true of the potential downside.

Worst Year for Shares vs Worst Year for Bonds


 
Source: Bloomberg. Returns for shares and bonds from 1994 to 2018.
Shares –38% in 2008, bonds –5% in 1994

Portfolio protection in uncertain times
Investment-grade bonds are a defensive asset class, offering stability and diversification in a portfolio. 2018 was a bumpy year for shares, but so far in 2019 shares have rebounded. The question is, where to from here?

When the sharemarket seems to be going up and up, it is easy to overlook the cushioning effect of a solid fixed-income foundation. But in volatile times it is increasingly important to ensure you protect the wealth you have built up.

Investors with balanced portfolios (50:50 bonds and shares) may find that in times of equity market stress, their bond returns can balance their losses.

Total Returns, Equities vs Bonds: 1 January 2018 to 31 March 2019
 

Source: Bloomberg and XTB

Bond coupons are fixed, share dividends are not
AMP, BHP and Telstra made cuts (and some increases) to dividend payments over the past year or so. No one complains when a dividend rises, but cuts are harder to swallow. Dividends are paid at the discretion of the company and are declared shortly before payment. In contrast, bond coupon payments are a legal obligation, decided when the bond is issued.

Is there a correct ratio of shares to bonds?
This is a personal choice for each investor, but it should not be a one-off decision. The ratio between fixed income and growth assets – or the split between shares and bonds – should change as you age.

There is a simple rule of thumb, coined by the late John Bogle, founder of Vanguard, that your bond allocation should roughly equal your age. Clearly not an exact science, but it demonstrates the increasing need for fixed income as we move through life.

Risks to be aware of
As with all investments, there are risks and it is important to remember that with higher yield comes higher risk, whatever asset class you are looking at. Much of the risk from owning bonds is driven by two factors:

  1. Time to maturity
  2. Credit quality of the issuer

By focusing on investment-grade issuers, the potential of a default can be minimised. The global default rate for three-year investment-grade bonds is 0.43 per cent, but jumps above 10 per cent for speculative-grade bonds.

It is rare for an ASX 100 company to go into liquidation, but is not unheard of. A large company with significant assets and a strong business model is more likely to be able to make coupon payments and repay the bond’s face value upon maturity.

If the bond you are considering has five years to maturity, you should consider if the company will be in existence in five years.

Choices for bond returns on ASX
A broad range of ETFs, mFunds and almost 50 different exchange-traded bond units (XTBs) provide access to bond returns on ASX.

Bond ETFs and funds provide investors with a very diverse range of bonds within one transaction. They have helped to open up access to this asset class and offer a simple way to buy and sell via ASX. But there is a key consideration for investors.

Bond funds and ETFs are continual – there is no end date and therefore they cannot provide a predictable return before you invest. And, being pooled products, new bonds are added or removed, sometimes on a daily basis, with potentially hundreds of bonds included. That is good for diversification, but it means investors do not know what their income or return will be.

Keeping the predictability in your ‘fixed income’
XTBs differ from ETFs and funds. Rather than being diversified, continual investments, each XTB mirrors a single, specific bond issued by one company.

Each XTB provides two known features:

  1. A coupon amount and payment schedule.
  2. A maturity date.

If you currently have little or no exposure to bonds and simply want a broad exposure to fixed income, take a look at the range of ETFs or mFunds available.

However, if you want the predictability of known income dates, known maturity dates and a known return before you invest, XTBs could be a better fit.

For those with an existing bond ETF, adding one or two XTBs could provide a complementary element of predictability.

Disclaimer
The information in this article is general in nature and should not be the sole source of information. It does not take into account the investment objectives or circumstances of a particular investor. Read the PDS that relates to that class of XTB before making an investment decision and 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.

About the author

Richard Murphy is the CEO and one of the founders of Australian Corporate Bond Company. Australian Corporate Bond Company was established in 2013 to develop the XTB fixed-income investment opportunity. More information on XTBs is available here. Cash-flows tools for XTBs and Fixed Income Starter Packs are other resources.

Download a copy of XTB’s eBook ‘An Investor’s Guide to Fixed Income’.

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.

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