Bonds case has added weight

Investors seeking diversification should consider bonds to get better returns and added protection over term deposits.

Summary: Evidence suggests that self-managed super funds are switching heavily into shares, but also retaining substantial amounts of capital in cash and term deposits. But, in terms of returns, bonds are providing much better returns than either cash or term deposits.
Key take-out: Many SMSFs are taking on more risk by investing in shares and using cash as a defensive asset class without considering debt securities.
Key beneficiaries: General investors. Category: Income.

The sharemarket has had a great run in recent months and there is some evidence that self-managed super fund (SMSF) investors are using their cash and term deposits to invest in much higher risk shares (see table 1 below) to increase return. Investment in debt securities (bonds) is very low right now, yet this area offers unique protection and better returns than term deposits.

The table shows cash has been slowly declining as a percentage of total assets over the last three quarters (from 30.05% to 28.62%) while listed shares has been growing over the same period (up from 29.32% to 31.65%). This suggests SMSF investors are using their cash holdings to buy shares. The table also shows direct debt securities holdings (including bonds) have increased in dollar value over the last five quarters but have declined as a percentage, and indeed make up only a very small percentage of total assets.

In summary, SMSFs are using cash as a defensive asset class and taking on much more risk by investing in shares to boost return without considering debt securities (bonds), which sit neatly between the two asset classes in terms of risk and return (see The bonds balancing act for more information).

Bonds offer exactly the same proposition as term deposits, that is, a known income and repayment of capital back at maturity. But bonds offer important protections over cash for minimal additional risk; given that additional risk, they also offer higher returns – important in this low interest rate environment.

Bonds offer fixed, variable and inflation-linked interest payments

Most term deposits are a fixed-rate investment. If interest rates start to rise investors have to wait until maturity to take advantage of higher rates on offer. They can break the agreement, but that usually involves a fee or loss of interest earned. There are three main types of bonds: fixed-rate like term deposits, variable or floating-rate, and inflation-linked.

Floating or variable rate bonds have an interest payment that is linked to a benchmark, and in Australia it’s the Bank Bill Swap Rate (BBSW). BBSW is calculated each business day. Floating-rate notes usually pay interest quarterly based on BBSW plus a margin. Let’s run through an example. Say the interest rate, set at first issue of the bond, was BBSW 3%. If BBSW was 3.25% at first issue, then the interest rate payable to the investor for that first period (at the end of the quarter) would be 6.25%. Now if BBSW increased during that first quarter, due to expectations that interest rates would rise, to say 3.75% at the first interest payment date, then the interest payment on that bond for the next quarter would be 3.75% 3% = 6.75%. In this way floating-rate notes keep pace with market expectations of interest rates. Investors don’t have to worry about losing out on interest rate rises, nor reinvesting for short periods.

Inflation-linked bonds work much the same way as floating-rate notes except instead of the interest payment being tied to BBSW it is tied to the Consumer Price Index, which measures inflation. So inflation-linked bonds provide a direct hedge against inflation (see the article “A bomb-proof bond portfolio for 2013” for more information).

Many commentators without a good understanding of the fixed income asset class still proclaim bonds will lose value in a rising interest rate environment. This is true of fixed-rate bonds, and these are the bonds that are most commonly issued by governments. But it’s clearly a misnomer in regards to floating-rate notes and inflation-linked bonds.

Interest is paid either quarterly of half yearly for most bonds

Interest on most term deposits is paid at maturity, although if the term exceeds 12 months it is usually paid annually. Banks will pay more frequent interest but the interest earned is usually reduced to compensate.

Fixed-rate bonds pay half-yearly interest and floating-rate notes and inflation-linked bonds usually pay quarterly interest, great for those investors in retirement wanting regular cash flow.

Liquidity – the ability to access your funds

Term deposits are not liquid investments, as investors agree to forgo access to those funds for a pre-determined period. If investors want to access their funds they are usually faced with break fees or penalty interest.

Bonds are generally liquid investments, that is, they can be easily bought and sold in the secondary market, where they are actively traded. There is no requirement to hold bonds until maturity. There are no fees as such to transact; brokers take a small margin between buyers and sellers, similar to the way foreign currency markets work.

Bonds offer the opportunity for capital gain

Because there is an active secondary market for bonds, their prices can fluctuate. Meaning there is an opportunity for capital gain. Fixed-rate bonds will show the greatest variances due to the fact their interest payment is fixed and if interest rates fall, these bonds will be highly sought after and the bond prices will rise. So, a TD will protect income as will a fixed-rate bond, but it is only the fixed-rate bond that has the capacity to increase in capital value. This provides an important protection, particularly when interest rates are moving lower and typically shares prices and often property prices will also be moving lower. The gains on fixed-rate bonds help offset losses elsewhere in your portfolio.

Bonds can trade at a discount (below the price they were first issued) or at a premium (above the price they were first issued). Buying bonds at a discount means that if you hold them to maturity, you can expect a capital gain.

A note of warning – selling bonds prior to maturity can result in a loss if the bonds are trading at a discount. But holding bonds to maturity will mean you receive the issue value (usually $100) back unless the company goes into liquidation or wind-up.

Better returns for a marginal increase in risk

Below is a sample of the bonds available in the wholesale market with yield to maturities of over 5%. Good one year term deposit rates are around 4.40% and you can get higher rates of up to 5% for five years, but you are locking away your funds and interest rates could well increase over that horizon.

Most of the securities below are bonds, although I’ve include two “tier 1” hybrids issued by National Capital Instruments (a subsidiary of National Australia Bank) and Rabobank. Both are entities where I have confidence that that banks will repay at the first opportunity (otherwise known as first call). If for some reason they fail to call the hybrids they would then be perpetual. All the other securities I’d call bonds as they have defined maturity dates. Yield to maturity ranges from 4.73% for the Mirvac fixed-rate bond with a maturity in September 2016 to 7.05% for the fixed-rate Silver Chef bond with a longer maturity date of September 2018.

I’ve also include two inflation-linked bonds as I really think these bonds are very good investments in the current environment. The yield to maturity assumes a 2.5% inflation rate (the mid-point in the RBA target band).

Summary

Bonds have protective qualities that aren’t available in other asset classes. Diversification as always remains key to protecting your wealth and bonds should feature in every investment portfolio.

Note: BBSW is really important in debt markets as it is used as the benchmark for pricing many securities. Before Easter the Australian Financial Markets association (AFMA) announced that the 12 member bank panel would no longer be used to set the BBSW rate. Previously the panel had consisted of 14 banks and two international banks had left given issues with setting other reference interest rates LIBOR and EURIBOR. AFMA announced that another two international panel banks would depart, so with only 10 members remaining, took the opportunity to restructure the calculation. For more information see www.afma.com.au.


Elizabeth Moran is director of education and fixed income research at FIIG Securities.