Bonds are an important part of any investment portfolio, yet they are often overlooked due to lack of understanding. The good news is they are fairly straight forward products.
What are bonds?
Bonds are a tradeable debt instrument that pays a set amount of interest (e.g. 5% per annum) for a set period of time (e.g. 5 years). At the end of the term of the bond, you get back your initial investment. Bonds are commonly issued by companies and governments.
It’s easiest to understand what bonds are by looking at an example. In the past, the Victorian Government issued $300 million of Green Bonds, the money from these bonds was used for “green” projects, e.g. LED traffic lights, low-carbon buildings and public transport. The investors that bought the bonds were lending the Victorian Government the $300 million, for 5 years, at an interest rate of 1.75% (the RBA Cash Rate at the time of issuance). This means that:
On Bond Purchase: Investors lend the Victorian Government $300 million
Years 1 to 5: Investors receive an interest payment of 1.75% p.a. for 5 years
End of Year 5: The Victorian Government repays the investors $300 million
Why Hold Bonds in your Portfolio?
The key reasons that people hold bonds in their investment portfolio are to:
The price of bonds moves around less than shares, making bonds a less volatile (i.e. less risky) investment. Adding bonds to a portfolio will generally decrease the risk of that portfolio, provided the bonds are at least investment grade (more on that next post).
The reason that the price of bonds moves around less than shares is due to their structure. When you purchase a bond, you are receiving an agreed interest rate, for a set period of time, and you will receive your initial investment back at the end of that time period. This provides an element of certainty around your investment returns.
The key uncertainty that comes with bonds is whether the borrower (the bond issuer) will be able to make the payments they have agreed to. As such, the credit quality of the issuer is very important. In purchasing a bond from the Victorian Government, there is a high degree of certainty around the Government repaying your investment. This high degree of certainty is reflected in the low interest payment of the bond. Because of the low risk, your return is only 1.75% a year from the Victorian Government.
Another reason people purchase bonds is for the income. Whereas share dividends can move around from year to year, an interest payment from a bond is fixed, either absolutely, or as a spread above the cash rate. Investing in bonds therefore provides more certainty for income planning than shares.
A final reason for investing in bonds is to preserve capital. When purchasing shares, it is possible for the share price to move around a lot, and potentially to fall to zero. When purchasing bonds, there is a high degree of certainty that you will get your initial investment back, provided you invest in a high quality company / government. Also, even if a company runs into trouble, as a bond holder you will get repaid before shareholders receive any payments. Getting paid ahead of shareholders helps decrease your chances of losing money if the company faces financial difficulties.
Quick Note: Bond Pricing & Liquidity
Despite the relative safety of bonds, if you need to sell a bond prior to maturity you may not receive your initial investment back. This is due to the inverse relationship between interest rates and bond prices. If you bought a bond in a time of low interest rates, and have to sell in a time of high interest rates, the price of your bond will have fallen and you are likely to lose money.
It is also worth noting that bonds are generally not as liquid as shares, which is often reflected in wider bid / offer spread i.e. you pay more to buy a bond than you receive when you sell one.
How to invest
When deciding to invest in bonds, you have a number of options:
Direct Investment: There are some bonds listed on the Australian Stock Exchange, the most common of which are the exchange-traded government bonds, including indexed bonds (which pay a rate that is tied to inflation). It is also possible to buy corporate bonds directly, known as XTBs (exchange-traded bonds).
If you do decide to buy directly, it is important to create a diversified portfolio to make sure that you do not overly concentrate either your:
Credit risk: the risk of not getting your money back, which is highest if you have lent to just one borrower; and
Interest rate risk: the risk that interest rates rise, making the interest rate you agreed to receive today look unattractive, and the price of your bond falls.
It is quite difficult to build a diversified portfolio by directly investing in bonds.
Passive Funds: Another option open to you is to invest in a passive fund, for example a bond exchange-traded fund (ETF). This will give you access to a diversified portfolio of bonds. One point to note here, not all bond ETFs are the same. A Government Bond ETF will have less risk, and consequently less return, than a Corporate Bond ETF. If you are purchasing a Corporate Bond ETF make sure to check what the average credit rating of the portfolio is, an average rating of less than BBB- is very risky, and if this risk is not reflected in a higher return, then you may be better off avoiding such an investment. We look more at ratings next week.
Active Funds: It is also possible to pay a fund manager to construct a diversified bond portfolio. The fund manager will manage both the interest rate risk, and the credit risk of the bond fund. There are some good fund managers out there, however they may be hard to find as the SPIVA report shows that only 12% of bond fund managers outperform passive funds over a 10 year time period.
Risk of Too Many Bonds?
Bonds are an important part of a portfolio, but should not be 100% of your portfolio. Bonds, like cash, are a defensive asset. This means they are helpful in reducing the risk of your portfolio, but this reduced risk comes with reduced return. According to Russell data over the last 20 years Australian bonds returned 6.8% compared to 8.7% for Australian shares.
Investing in a portfolio of high quality government bonds, like the Victorian Government Green Bonds, could expose your portfolio to inflation risk. Over the last 20 years inflation has averaged 2.5%, if you were receiving only 1.75% on your bond portfolio, then the real value of your portfolio is slowly being eroded over time.
There are also other risks of investing in bonds, which we have touched on here (like credit risk and interest rate risk). Next week we explain in more detail some of the risks of investing in bonds, and how best to manage these risks within your portfolio.
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