Can a private investor still buy bonds?

In today's Big Question, subscriber Rosemary Mackenzie of Kensington, Sydney, asks: Can a private investor still buy bonds? George Nikas of Deutsche Bank Private Wealth says you can buy government bonds for as little as $1000 (if you really want to).
There appears to be a common misconception that investing directly in bonds is the domain of institutions. This seems to have arisen from the onerous minimum investment requirements set by large investment banks that are seeking to target institutional clientele.

Any investor can buy government and semi-government bonds on the primary market (when they are first issued), or on the secondary market. This can either be done through a few select banks such as Macquarie, or directly via the Reserve Bank of Australia. Minimum investment amounts vary, but may potentially be as little as $1000.

Investors may buy Treasury Fixed Coupon Bonds or even Treasury Capital Indexed Bonds (CPI Bonds). Treasury Fixed Coupon Bonds pay interest on a semi-annual basis at a predetermined coupon (on the face value amount). At maturity, the face value is repaid. Treasury Capital Indexed Bonds pay interest on a quarterly basis at the predetermined coupon rate, applied to the face value, but the face value is indexed to inflation.

Bonds issued by corporations, unfortunately, have onerous minimum investment amounts (usually $500,000 face value).

Smaller investors may also invest in bonds indirectly via managed bond funds. These investors, however, need to be mindful of fees potentially eroding returns. Bond fund managers may attempt to actively manage the fund to add value through duration, yield curve positioning, sector and security selection.

Are some bonds better than others in terms of value and return?

Although some bonds may appear to be better than others in terms of return or yield, it is important that credit risk be taken into account and that they are compared on a like-for-like basis. For instance, bonds issued by a state government may offer a relatively higher yield (ie, spread) over bonds issued by the Commonwealth Government. This spread may vary over time and between issuers, which is reflected in the price at which the bonds trade, implying in some instances that there may be better relative value on one bond over another, even after risk is taken into account.

Are Australian Government bonds available or are these out of fashion?

Notwithstanding the reduced supply of Australian (Commonwealth) Government bonds triggered by lower government debt levels, there is still ample supply. However, the inverted nature of the yield curve (where short-term interest rates are higher than long-term bond yields), has provided no incentive for investors to invest in longer-dated bonds.

This disincentive has been amplified by the duration risk, where rising long-term interest rates or bond yields may translate into short-term capital losses on a longer-dated bond (if it is sold prior to maturity). As a result, many smaller or retail investors have increasingly become attracted to higher risk alternative income assets such as structured credit, floating rate credit, high-yield (including the recent problematic high yield property sector) or emerging market bonds, as well as hybrids.

It is fair to say that Australian Government bonds have increasingly become out of favour in both the retail and institutional space. It will be interesting to see whether the recent upward shift in bond yields (and associated flattening of the yield curve as demonstrated below) has any material impact on demand for longer-dated bonds.

What are the risks, beside currency, if overseas bonds are the recommendation?

In addition to the duration risk identified above, one needs to be mindful of credit risks when investing in overseas bonds or global sovereign debt. For instance, while US Treasuries offer a relatively lower yield vis-à-vis emerging market bonds / debt, the risk of default is much, much lower.

Investors need to ask themselves whether the incremental yield they are receiving over Treasuries (ie, the credit spread) is sufficient to compensate for the incremental risk of default on emerging market (government) debt. One also needs to be wary of investing in the corporate debt of a company based in an emerging market.

Interestingly, the credit spread on emerging market debt has contracted materially in recent times, implying that investors have become increasingly comfortable with the ability of issuers to repay debt obligations. However, a blowout in credit spreads on lower-rated (sub-investment grade) debt (from say 200 basis points to 500 basis points) has the potential to translate into material capital losses of up to 10% on global emerging market bonds. Therefore caution is warranted

* George Nikas is an executive with Deutsche Bank.