Bonds should star in SMSF portfolios

Members of self-managed superannuation funds are not generally big fans of bonds, but that could change as fund members move toward retirement.

The high allocation of SMSFs to shares reflects both shares' strong track record of generating wealth and the tax-effectiveness of fully franked dividend income. There is also increasing awareness of increasing life expectancy, and the consequent need to make capital last longer, too. Even in retirement, people will still need the returns from shares to replenish their funds.

But equally, the global financial crisis showed starkly the effect of over-exposure to shares. Investors know full well that a GFC-style market slump -- which saw the Australian market lose 57 per cent of its value, and take five years to regain its previous index high -- can happen.

In particular, the concept of ‘sequencing risk' -- the risk that the sequence of portfolio returns hurts the investor -- is becoming more widely understood.

An investor who retired at the worst of the GFC market downturn in March 2009 took an awful loss. For that investor, having an income strategy built around tax-effective share dividend income ignored the volatility of the actual share prices -- and they suffered accordingly.

In contrast, bonds' usual lack of correlation to shares can help balance portfolio returns if the sharemarket falls when you happen to be retiring.

Retirement planning is starting to factor in ‘floor/upside' strategies. These strategies stress the importance of an income floor: an income source as close to certain (or guaranteed) as possible. This enables the investor to meet the most important living expenses before looking for upside through exposure to shares. Under these strategies, the floor of safe cash-flow streams is built first, and then upside is created using shares. This extends the floor over time.

Term deposits have a role to play in the safety of a portfolio being built for retirement, as well as the income floor, but they should not be the only things considered.

The spectrum of bonds, from risk-free (if held to maturity) Commonwealth government bonds, through semi-government bonds issued by the state governments, to corporate bonds, can offer a wide range of yields and thus fill a range of risk appetites.

Currently, Australian Commonwealth government bonds earn in the range of 2.5 per cent to 3.6 per cent, depending on volume and maturity. Five-year top-rated senior corporate bonds push this out to the range of 3.6 per cent to 3.8 per cent, while sub-investment-grade issues from well-known issuers like Qantas Airways can get close to 7 per cent.

In the riskier listed interest-rate securities market on the Australian Securities Exchange where there is a group of corporate ‘hybrid' securities (the term for issues that have both debt-like and equity-like features embedded in them), the annual yields can go as high as 7 per cent-plus. Within these parameters, a bond and listed interest-rate securities portfolio can be built to target whatever portfolio yield the investor wants given their risk appetite.

Using bonds can help a SMSF get protection from interest rate moves, by using a fixed-rate bond, or participate in interest-rate moves by using a floating-rate issue. In particular, floating-rate bonds help investors gain the benefit of rising rates, without trying to time the roll-over of their term deposits. And inflation-linked bonds provide the only direct hedge against inflation available in the market, to protect the purchasing power of a portfolio.

Bonds are also liquid in a way that term deposits are not. The latter often apply a ‘break fee' if you need to get access to your funds prior to maturity. Bonds can be bought and sold at any time (subject to liquidity). While a portfolio should always have a cash holding of say, 10 per cent, an investor with an allocation of any more than that to cash and term deposits should look at putting some in bonds.

A recent report from Credit Suisse compared a portfolio split 50:50 between Australian shares and ten-year Australian government bonds, and a portfolio split 50:50 between Australian shares and term deposits. The shares/government bonds portfolio had lost money in only three of the past 34 years, while the shares/term deposits portfolio had lost money in just five of the past 34 years.

That sounds like only a small difference, but it meant that $100 invested in the shares/government bonds portfolio in June 1979 had appreciated to $4,740, while the same amount put into the shares/term deposits portfolio at the same time had grown to $2,820. In a retirement portfolio, that kind of difference can end up making for an uncomfortable shortfall on expectations.