Category: Investing

Shares, Stocks or Equities?

In this post we cover what shares are and why you would invest in them.

Shares are also known as equity, or stocks.  We will use all three terms interchangeably.

What are Shares?

When you buy shares in a company, you are buying part of the company, meaning that you become a part owner of the company. As a part owner you have the right to:

  • Share in the profits of the company:  Any profits that are distributed to shareholders will be paid to you as a dividend.  Dividends are usually paid semi-annually.

  • Vote:  When key decisions are made in the company, as a shareholder, you will have the right to vote.  For example, you may get to vote at the Annual General Meeting (AGM) about which directors to elect, or how much company executives should be paid.

Shares are very different from bonds.  When you invest in bonds, you are lending money to a company.  When you purchase shares, you are becoming a part owner of a company.

Why Invest in Shares?

Shares are a key part of any investment portfolio. The top reasons why you would invest in shares are:

Capital Growth: Australian shares generated a higher investment return than either cash or bonds, with an average per annum return over the last 20 years of 8.70%.  Investing in shares helps grow your investment (also known as capital) over time and achieve a portfolio growth rate that is ahead of inflation. 

Dividends and Franking Credits: Some people invest in shares for the income provided by dividends.  A further benefit, when you invest in Australian shares, is the franking credits that some shares provide. 

A Franking Credit is a credit you receive for the tax that a company has already paid. A company will usually pay tax on its profits at a rate of 30%, if the dividend you receive is franked, you will receive a tax credit for the amount of tax that the company has already paid on that dividend.  This will be particularly beneficial if your marginal tax rate is below 30%.  For example, if you hold the shares in your superannuation account:

  • Prior to retirement (i.e. during the accumulation phase of your super):  Any income you receive is taxed at 15%.  This means that if you invest in shares that pay a fully-franked dividend, you’ll receive a tax credit of 30% and only pay tax of 15%, leaving you 15% better off.

  • In Retirement (during the pension phase): You don’t pay any tax on the income generated from your superannuation account.  If you invest in shares that pay a fully-franked dividend, you’ll get the full benefit of the 30% tax credit.

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.

The Risks of Investing in Bonds

In this post we cover the key risks of investing in bonds, including interest-rate risk, market risk and credit risk.

What are the key risks of investing in bonds?

Bonds are less risky than shares, but they do still contain risk.  Below we outline some of the key ones:

Interest Rates

The price of bonds can move around depending on the level of interest rates.  For example, say that you bought the Victorian Government Green bond in 2016 which pays an interest rate of 1.75% p.a.  The cash rate at the time the bonds were issued was 1.75%, meaning you were getting paid the cash rate at the time of purchase.

Fast forward to 2020 and the cash rate is 3.50%, now you own a bond that is paying you 1.75% less than the cash rate.  Investors would rather buy a bond that is paying them the 3.5% current cash rate than one paying them 1.75%.  Because of this, the price of your 1.75% bond has gone down.  At the end of the 5 years, you will still get your $1,000 back, but in the intervening years the price of your bond will move around and you will have missed out on the additional 1.75% return that other investors were able to earn during that period.

Inflation Risk

Because bonds are generally lower risk, they also offer lower returns.  This introduces the possibility that your return may not keep up with inflation.  For example, the interest payment on the Victorian Government Bond of 1.75% is below the average inflation rate of 2.50%, which means that at the end of the 5 year term the purchasing power of your investment will have fallen, introducing the risk that during the term of your investment you may have lost money in real (i.e. inflation-adjusted) terms.

Credit Risk

In buying a bond, you are essentially lending money, leaving you exposed to the credit risk of the borrower.  A bond is a legally binding obligation to repay the debt, however a company (or Government) in bankruptcy may not have the money to repay.  As such, you should be happy with the risk of the company you are buying a bond from.

One of the key ways that people measure credit risk is via a credit rating, you can read more about them here.  The ratings go from AAA (lowest risk of default) to C (highest risk of default).  The higher the risk of default, the higher the interest rate that the bond should pay.  To minimise risk, it is generally best not to invest below a BBB- rating.

The Victorian Government is rated AAA, meaning that there is a low risk of default, which is why the interest rate is so low at 1.75%.  It is worth noting that credit ratings can change, which may impact the price of your bond. If you invest in a AAA rated bond, which is subsequently downgraded (e.g. to AA), then the price of the bond is likely to fall.

Market Risk

Bonds are part of the financial markets and are subject to falls in prices when the bond market declines.  For example, when interest rates begin increasing, the bond market as a whole usually falls due to the inverse relationship between bonds and interest rates.

Bonds are also impacted by the share market.  A study found that in periods of market volatility, the correlation between the bond and share market can get up to 0.50.  This means that if the share market drops by 1%, the bond market could drop by 0.50%.    

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.

All About Bonds

This week we cover everything you never wanted to know about bonds, the unloved asset class 🙂 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’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:

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% – 3%) 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 (“ETF”).  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 – High 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.

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