Category: Blog

All About Bonds

This week we cover everything you never wanted to know about bonds, the unloved asset class ūüôā Learn when to include them in your investment portfolio, which type, and the returns you can expect.

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‚Äôs 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 ‚Äúgreen‚ÄĚ 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:

Reduce Risk

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.

Income

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.

Preserve Capital

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.

The information on this website is for general information purposes only. It is not intended as  financial or investment advice and should not be construed or relied on as such. Before making any commitment of a financial nature you should seek advice from a qualified financial or investment adviser. No material contained within this website should be construed or relied upon as providing recommendations in relation to any financial product. Balance Impact does not recommend or endorse products and does not receive remuneration based upon investment or other decisions by our email recipients, publications, newsletter or website users.

Investing & Cash

Everyone knows what cash is, but do you know how to get the best return for your cash, or why you should have it in your portfolio? In this post we cover the basics of cash.

Everyone knows what cash is, but do you know how to get the best return for your cash, or why you should have it in your portfolio? This week we cover the basics of cash as an asset class.

Why hold cash in your portfolio?

The key reasons that people keep cash in their investment portfolio are to:

Minimise risk:   Cash is the ultimate risk free asset.  The government provides a guarantee of up to $250,000 for any deposits held with an authorised bank, credit union or building society.  This means that if a bank goes bankrupt, the Federal Government will make sure that you get your deposit back, up to a maximum amount of $250,000.  Keeping some amount in cash helps reduce the total risk of your investment portfolio.

Liquidity:  Liquidity is a financial term referring to how quickly an asset can be converted to cash.  Shares in large, well-known companies are very liquid because you can sell them immediately on the stock-exchange and have the cash in a few days.  Your house is less liquid, as it would take a minimum of a few months before any proceeds from a sale would arrive in your bank account.  Cash is the most liquid asset.

Having access to some cash is important, it gives you the flexibility of being able to access money without being forced to sell your assets in an unfavourable market.  For example, if you plan to spend $10,000 on a holiday this year, then it is best to keep that amount in cash.  Otherwise the $10,000 you saved up and invested in shares, might be worth only $6,000 by the time you are ready for your holiday, if you have to sell in an unfavourable market.

It is important to have enough cash on hand to meet your short term expenses.Generally if you think you’ll need to access the money anytime in the next three years then it is best to keep the money in cash.

Opportunistic:  If you can’t find a suitable investment opportunity, then it may be worth keeping your money in cash until you do.  Then, when a suitable opportunity arises you will be ready to go. 

Where to hold it?

Cash, like any other investment, needs to earn a return.  The return will depend greatly on where you hold it.  Your options are:

Standard Bank Account:  This is the lazy option, and you’ll pay for it by way of abysmal returns.  Most standard bank accounts pay interest of close to 0%.

High Interest Saving Account:  This is a better option, particularly for money that you don’t need to access day-to-day, as these kind of accounts generally have limited accessibility (e.g.no ATMs).  Many providers offer high introductory rates (currently around 3%).  If you do take advantage of an introductory rate, make a diary note 2-3 weeks prior to the end of the introductory rate so that you can shop around for another introductory rate.

Term Deposit:  A term deposit is money that you deposit with a financial institution for a particular length of time, anywhere from 1 month to 5 years.  The benefit is that term deposits usually pay a higher rate (currently between 2% Р3%) than leaving your money in a standard bank account.  The downside is that if you need to access the money before the end of the term, you will forfeit some or all of the interest.

Exchange Traded Funds:¬† It is possible to invest in cash via an exchange traded fund (‚ÄúETF‚ÄĚ).¬† This means that you can purchase the cash ETF on the stock exchange (the same way you would a share) and get access to a number of term deposits.¬† The upside is that someone else is managing your cash with the goal of maximising the interest rate.¬† The downside is that you will pay a fee for this management.

Cash Management Fund:  It is also possible to invest in a cash fund managed by professionals to maximise the return from your cash.  Like all funds, you will pay a fee for this service.

Too much cash?

If you are a worrier, you might be tempted to hold all your assets in cash, given the low risk.   However, it is possible to hold too much cash in your portfolio.  Cash is very low risk, and consequently the return is also low.  The bare minimum investment return that you should expect from your portfolio is inflation.  The reason that $100 is worth more today than in 10 years’ time is due to inflation. 

If you are earning less than inflation, then the purchasing power of your money is slowly being eroded.  Over the last 20 years inflation has averaged 2.5% per year, this means that you should aim to earn at least 2.50% p.a. on your portfolio.  This is not always possible with cash, as such, some of your investments should be held in other assets.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.

Asset Classes

What is an asset class and which one should you invest in?
We set out the characteristics of the three main asset classes (cash, bonds, shares) and the pros and cons of investing in each.

What is an asset class and which one should you invest in?

Asset Class Selection

There are three main asset classes; cash, bonds and shares.  The characteristics of each are set-out below:

Asset Class Purpose Risk Time Frame Investment Options
Cash Have money available for short term cash needs Low Short term High interest savings accounts, term deposit, cash exchange traded funds
Bonds Earn income and protect capital Low РHigh Short to medium term Directly through purchasing Government bonds (low risk) to junk bonds (high risk).

Indirectly through bond exchange traded funds, actively traded bond funds

Property Earn income via rent and increase the value of your investment over time through property price increases Medium – High Medium to long term Directly through purchasing a property.

Indirectly through a property exchange traded fund, a property managed fund, or through shares in property companies

Australian Shares Earn income via dividends and increase the value of your investment over time through share price increases High Medium to long term Directly through shares purchase.

Indirectly through equity exchange traded funds, equity actively managed funds.

International Shares Increase the value of your investment over time and spread your risk globally, rather than being concentrated in the Australian market only High Medium to long term Directly by purchasing shares on foreign stock exchange.

Indirectly through equity exchange traded funds, equity actively managed funds.

In our masterclass series we delve into each asset class (see links above) to explain exactly how you can invest in it, and why you may want it to form part of your portfolio.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs and before acting on the advice.

Passive v Active Investing

Investment Style: Passive or Active

Will you follow an active or passive investment style?

The two styles are very different:

 

Active Passive
Belief It is possible to beat the market. It is not possible to consistently beat the market.
Approach Use research and skills to pick the best securities to invest in. Invest in the market.
Fees Charge a higher fee for research and skills. Charge lower fees.

What the data says

The data suggests that the majority of fund managers do not beat the market:

Category Percentage of funds that beat the market over 5 years
Australian Shares 31%
Australian Shares- Mid & Small Cap 29%
International Shares 10%
Australian Bonds 18%

Source: SPIVA Australia Scorecard Mid-Year 2018

The data above is over a 5 year time period.  Over the 10 year and 15 year periods the managers of small-cap stocks (i.e. smaller companies listed on the stock exchange) have been shown to outperform the market.

What does this mean for you?

If you are going to be driven by data, then you would use a passive management style to invest, potentially making an exception for small-cap stocks.

Passive

If you follow a passive investment strategy then your main investment tool will be exchange-traded funds (‚ÄúETF‚ÄĚ).

An ETF gives you access to an entire market (e.g. the top 200 shares in the Australian market, known as the ASX200) through one single purchase on the stock exchange.

Fees for an ETF are lower than for an actively managed fund, they are more likely to be between 0.10% – 0.50%.

Active

You could be the exception to the rule and beat the market.  You have two options to do this:

  • DIY: Do the research and make the investments yourself.

Make sure you have the time and technical skills required for the due diligence on each investment, and that you have some kind of advantage (e.g. in depth knowledge of an industry) over professional fund managers.

  • Pay an active manager – you could outsource the investment decision by paying a fund manager to manage your money.

The cost is typically 1 ‚Äď 2% of the amount that you invest.

The information on this website is for general information purposes only. It is not intended as  financial or investment advice and should not be construed or relied on as such. Before making any commitment of a financial nature you should seek advice from a qualified financial or investment adviser. No material contained within this website should be construed or relied upon as providing recommendations in relation to any financial product. Balance Impact does not recommend or endorse products and does not receive remuneration based upon investment or other decisions by our email recipients, publications, newsletter or website users.

 

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