Bonds: Australia’s forgotten asset class

Long ignored by Australian investors, bonds are now being seen by SMSFs as the middle ground between term deposits and shares.

Australians are generally not as interested in bonds as they are in shares. This probably has a lot to do with the nation’s surge over the last decade to be one of the largest share-owning nations, as measured per head of population. 

European and US retail investors, however, are far more likely to invest in bonds. But the bond market in Australia has never been a retail investor market, accessible only through managed funds. However, this is beginning to change as bond brokers break-down the minimum parcel sizes of wholesale government, semi-government and corporate bonds into smaller parcels to meet the demand from self-managed superannuation funds.

To a large extent, SMSFs use dividend income from shares as a major source of income, buttressed by term deposits, which offer them greater certainty of payment. Australia’s system of dividend imputation in Australia, where investors receive a dividend personal tax credit on the company tax already paid by the company, is a highly effective generator of tax-effective income streams. This is particularly true for SMSFs, where the low super tax rates and the rebates of unused franking credits can effectively ‘turbo-charge’ nominal returns, therefore usurping the role that bonds play in other investment markets.

In Australia, bonds do not have the tax advantages of shares in terms of the effectiveness of franked dividends in generating income, as the bond interest and any capital gain is fully taxed. But nor do they bear the capital risk and volatility.

However, bonds are starting to be seen by SMSF investors as occupying the middle ground between term deposits and shares, thus playing a very useful role in an investment portfolio. 

Bonds are a loan security: you lend money to a government or a company, and it undertakes to pay you interest on the due dates (at the ‘coupon’ rate) and pay back your principal (the face value) at maturity. 

Like a term deposit, bonds have a known rate of return upfront, so you have that certainty, and they also represent a legal obligation on the borrower. This makes bonds one of the few asset classes where you know what your returns will be over the life of the holding.  

When it comes to income, the critical difference between a bond and a share is that in a bond, the company must return to you interest and your principal when it says it will do so. With a share, there is no actual obligation on the company to pay a dividend. Share dividends can be cut -- or even not paid -- at the company’s discretion.  

Because of this greater certainty of income, bonds, like cash investments, are defensive assets that can protect your portfolio through tough times. Augmenting this quality is the fact that bonds generally perform differently to shares and have less volatility. And unlike term deposits, bonds are liquid and you can sell part of a holding at any time to fund cash requirements. 

The Australian marketplace offers several different kinds of bonds. There are fixed-rate bonds, floating-rate bonds and inflation-linked bonds, all of which work differently in different economic conditions.  

Fixed-rate bonds, as the name suggests, offer a rate of return that does not change. The second type of bond is the floating-rate bond, which has its coupon set at a margin over a benchmark, for example the bank bill swap rate. As interest rates change, the interest paid to investors will rise or fall. The third is inflation-linked bonds, in which the interest payments are adjusted for changes in the consumer price index (CPI), which measures inflation. The value of any CPI increase is added to the capital value of the bond. The ‘linkers’ pay a lower interest rate for the life of the bond to compensate for the fact the capital value will increase with inflation. This means that, unlike nominal bonds, linkers pay a known real (after-inflation) rate of return.

Bonds differ widely between issuers (borrowers). Bonds issued by the US Treasury are considered the safest investments in the world in terms of the reliability of the borrower to pay interest and return principal. In Australia, Australian government bonds play that role. These are ‘sovereign’ bonds. But government-owned entities and companies can also issue bonds.

Sovereign bond issuers usually carry the highest credit ratings available, as do the elite of the world’s banks. Other banks are lower in the credit rating scale, and companies even lower. Some companies do not have an ‘investment-grade’ credit rating (a rating of BBB- or higher from Standard & Poor’s, or Baa3 or higher from Moody’s.) 

Being much more risky than sovereign bonds -- and riskier than investment-grade bonds -- sub-investment-grade bonds offer correspondingly higher yields. (Companies without a credit rating at all offer even higher yields.) 

An allocation to all three types of bonds -- fixed-rate, floating-rate and inflation-linked -- can help to ensure that a portfolio is protected under any scenario. Bonds can play a role in alleviating sequencing risk (the risk of getting the worst returns at the worst time), which affected many investors, who were heading into retirement overweight in shares in 2007–2008. Inflation-linked bonds can provide a known real (after-inflation) return, protecting investors’ purchasing power in retirement, as well as helping with longevity risk (the risk of outliving your savings), as virtually the only direct hedge available against inflation. 

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