A simple approach to bonds

Self-managed super fund trustees may relish the control they have over their financial destiny but the investment decisions they make are sometimes significantly different from what the professionals are doing.

One of the asset classes DIY funds hold at levels far below retail and industry super is fixed income. According to the Australian Taxation Office at June last year nearly $7 billion of the $571 billion in SMSFs was held in debt securities, or about 1.2% of funds. By way of comparison the InvestSMART Balanced Model Portfolio is 27% invested in fixed interest.

So what’s going on?

A MISUNDERSTANDING

It’s not that SMSFs are avoiding defensive assets — more than 27% of capital is squirrelled away in cash accounts and term deposits. Some SMSFs and many retail investors go a bit further out on a limb and invest in hybrids, which are listed securities that generally pay a fixed margin above the cash rate. As interest rates rise and fall the capital values of these instruments fluctuate, but the trick is to buy at a level where you are happy with the yield to maturity. For many hybrids, however, the maturity date is a relative concept as the issuer may choose to transfer the debt into equity if a trigger event takes place. Hybrids are risky.

PASSIVE OPTIONS

A simple way to hold fixed income is with an exchange-traded fund, and at the start of March 10 Australian fixed income ETFs and five global funds were available on the ASX.

Passive fixed income funds often don’t replicate the index they track down to every last bond. Instead, they will assemble a portfolio that mirrors the underlying index as closely as possible. For example, the iShares Composite Bond ETF holds 330 instruments, or less than half the number of bonds in the Bloomberg AusBond index it tracks. More than 72% of bonds in the ETF are AAA-rated and 89% are issued by federal and state governments, the remainder being corporate debt.

KNOW THE KEY CRITERIA

Managers of bond funds are obsessed with a few key stats for the portfolios they manage. Three important measures are: duration, which is a measure of a bond’s price sensitivity to changes in interest rates; yield to maturity, or the expected return from coupon payments and changes in the price of the bond, and; average credit rating of issuers. Investors are also interested in the management fee.

The table shows a summary at early March for the Australian fixed income ETF market.

RISK AND RETURN

At a glance, global funds look like a better option as expected yields to maturity are higher than for ETFs that hold local bonds. Be aware though that interest rates in many parts of the world are extremely low and as they rise the capital values of bonds can be expected to fall. As interest rates change, a fund’s duration in years can be expected to determine its performance. For example, when interest rates rise, the prices of long-term bonds can be expected to fall more sharply than the prices of shorter-term bonds. All else being equal, a fixed income index fund with a long duration will be expected to lose more in value than a fund with a shorter duration.

Measured for the credit quality of bonds they hold, the global funds are significantly inferior to the ETFs over local bonds. A fund with lower average credit rating and shorter duration may look good in a benign market but when volatility hits liquidity can evaporate rapidly. In that scenario capital can take a heavy hit. The expected yields for global bond ETFs are best estimates. There are no guarantees.   

THE OUTLOOK

The investment class was a great shock absorber during the GFC, when central banks pushed rates down sharply to encourage spending. Today the outlook for bonds is not so appealing, but they are still a great diversifier and SMSFs that are overweight cash should think about fixed income as an option.