A retail bond wishlist

PORTFOLIO POINT: A retail bond market would satisfy a money-hungry federal government and equity-shy investors.
Australian governments need to raise about $300 billion over the next few years to fund future deficits and stimulus packages. It may have already started. The Australian Office of Financial Management (AOFM), responsible for managing the government’s debt, took offers on Wednesday (February 25) for $600 million of bonds offering a coupon rate of 6.5% payable until May 2013.

I doubt anyone asked you if you were interested. While selling Treasury bonds to institutions and large superannuation funds is the easiest way for the government to raise money, this wastes an important opportunity to help the long-suffering retail investor.

Here are four bond innovations that should be considered by Treasurer Wayne Swan and Nick Sherry, the Minister for Superannuation and Corporate Law, to improve your investment toolkit while still satisfying the government’s growing appetite for money.

Bring back the Australian savings bond

Unlike many other countries, Australia does not have government savings bonds directly accessible to retail investors. Instead, investors are forced to deposit money with risky banks (let’s not forget why the guarantee is necessary) or invest in a confusing array of bond funds through fee-taking intermediaries. Australian savings bonds were issued between 1976 and 1987 and fulfilled an important consumer savings role.

While many investors naively chased yield without properly assessing the risk, a few could probably have been saved from the likes of Estate Mortgage, Fincorp, Basis Capital, Macquarie’s Fortress and more had simple savings bonds been available as an alternative or at least a benchmark. It is possible that more money has been lost by hapless Australians in fixed interest investments than in equities or property.

Australian savings bonds could become a staple investment for Australian self-managed super fund portfolios. These could be applied for cheaply online, perhaps via a linked bank account as some do to access ING Direct, for example. As before, they should be for a fixed period, say five or 10 years, and be redeemable with a month’s notice. Just as discounts were offered to encourage investors to become equity holders during past privatisations, perhaps yield-related incentives could be offered to make Australians better savers. Surely the government would benefit from directly accessing “sticky” money from local retail investors.

Introduce inflation-linked bonds for the masses

As I pointed out in a previous article (see The trouble with wealth projections), one of the greatest threats to retirement security is not poor investment periods like now but periods of prolonged high inflation as we had in the 1970s. Many don’t realise that bonds are a riskier investment over the long term than equities if your goal is to reliably maintain purchasing power.

The table below shows that 20% of the time bonds did not beat inflation over rolling 30-year investment horizons going back to 1875, while equities always did. This confirms the findings of Jeremy Siegel, a professor of finance at the Wharton School, who studied US bond and equities returns over the last 200 years.

Range of annualised real inflation-adjusted returns over rolling 30-year periods from 1875 to 2008
comparing Australian equities and the yield from 10-year Australian bonds

In the current environment, it is feasible that some governments might encourage inflation to reverse deflation, to depress the real value of their growing indebtedness and/or as a way to stealthily raise taxes through bracket creep. Just because asset deflation is today’s problem doesn’t mean it won’t be tomorrow’s. Those investors who may have crystallised losses, converting depressed equity values into cash, may become further shattered to see the real value of their cash erode next. A real risk chasing traditional bonds while interest rates are low is to suffer capital loss when interest rates rise.

An antidote to this is to introduce inflation-linked bonds whose investment return is adjusted for inflation. These bonds are widely available in the US as Treasury Inflation Protected Securities (or TIPS). They are far less common in Australia, although some semi-government institutions still offer these and a few federal government bonds released decades ago may still be in circulation.

Inflation-linked bonds are of immense value to retirees and other investors seeking to insulate their portfolio from the ravages of inflation. Properly structured, these bonds could take over half a retail investor’s fixed interest allocation.

These bonds should also be offered directly to retail investors perhaps as another variant of the Australian savings bond. It could prove to be a more attractive alternative to a standard savings bond, which must compete with high-yielding bank term deposits. Rather than providing the inflation protection at maturity as some bonds in this class do, I would rather these be structured to pay an ongoing yield equal to a margin above CPI. This would help those living off their investments to better adjust to rising costs.

Transferring the risk of inflation through these bonds back to the government is a win for investors while it potentially also lowers the government’s cost of funds (assuming inflation doesn’t break out). You might take comfort knowing it also makes the government equally sensitive to Glenn Stevens and the Reserve Bank’s efforts to fight inflation.

Live long and prosper using a longevity bond

Over the past few decades, individuals have gradually taken over responsibility for funding their retirement and can no longer rely on others providing for them other than a safety net existence. This happened as defined contribution savings plans were introduced and defined benefit plans were retired. Right about now some will be thinking they have been given a hospital hand pass, although there are a few corporate plan members who will be hoping their fund isn’t insolvent. I suspect up to half of all Australians have been disadvantaged by this great shift for two main reasons:

• Not all are good investors or able to seek out good advice: too many don’t stick to a strategy or have the wrong strategy.

• Individuals need to set aside more capital than those in a group scheme that pools and averages out the risks of a) retiring into the worst investment or inflation conditions; and b) living longer than the average.

While inflation would be addressed by my earlier recommendation, introducing a “Longevity Bond” styled product would also address these problems. Exactly how a bond like this would work would take some thinking, including perhaps from award-winning economist Robert Shiller who has also suggested these. There are probably a few recently unemployed investment bankers who could help design them.

Annuities offered by life insurance companies used to address this but they have fallen away in importance for a variety of reasons. Perhaps when you and I turn 60 we tip over some of our savings into a bond, which pays us back every year until we die from a pool of savings from all who share the same birth year. Funding of this could also be linked to future rises in compulsory superannuation savings.

Take a punt on bonus bonds

Finally, we are a nation of gamblers yet we leave it to our Kiwi cousins to offer a lottery-like bonus to bond holders. Since 1970, 44 million prizes totalling more than $NZ1.5 billion has been paid out to New Zealand bond holders. Statistically, you have a 1 in 10,000 chance of winning the first prize of $1 million, a second prize of $100,000, a third prize of $50,000 and other lesser prizes.

Given that you are also earning interest income, this has to be better than putting your money into a poker machine, which gives you only a 40–45% chance of doubling your money. Given his stated anti-gambling position, the government could use this as a negotiating ploy next time it needs independent senator Nick Xenophon’s support!

It’s hard being a retail investor these days. There is plenty of reason lately to think “the system” has been designed for everyone but you. These retail innovations, and especially Australian retail inflation-linked bonds, could bring some long-needed relief. I encourage you along with me to champion these to government.

Doug Turek is the managing director of personal wealth advisory firm Professional Wealth.