Get smart - the name is bond

Between low-return deposits and high-risk shares, there's a third way, writes Mark Bouris.

Between low-return deposits and high-risk shares, there's a third way, writes Mark Bouris.

THIS week I asked my Twitter followers where they would invest $10,000 to get a good return over 12 months.

The results weren't surprising. Almost two-thirds said they would invest in just three asset classes: property, shares or a savings account.

As a person who has worked in financial services for a long time, I noticed the glaring omission was government, bank and corporate-issued bonds - just 4 per cent of responses thought to invest in them.

I'm not pouring scorn on these choices - I think it's clear that people don't talk about bonds because they haven't been educated about them.

Simply, bonds are debts. When called a corporate bond, they represent a borrowing made by a company, which offers an interest rate to encourage you to lend to them.

Ironically, a bank-issued bond is very similar to a bank deposit. When you put your savings on deposit, you are literally lending money to a bank. Banks also borrow from big investors by issuing them bonds. As you can imagine, institutions frequently demand higher returns than you get on your savings accounts!

Bonds are an attractive savings destination for many big investors because they offer stable returns with relatively low risk.

For example, today you can get nearly 6 per cent a year on a senior-ranking, variable-rate bond issued by one of the big banks. And many of these investments are very liquid: you can put your money in and take it out whenever you want.

The rate of return you get on the bond is usually tied to how secure it is. This refers to the risk that you will not get paid your interest, much like the way banks think about the risk of you defaulting on a home loan.

If you can get better risk-adjusted returns on bonds, why is it so rare to be offered them?

The financial regulations say the standard minimum investment in a bond is $500,000, which means they are usually limited to the big end of town.

This is supposed to protect "mums and dads" from bad decisions. But it's actually unfair because none of you are stopped from buying far riskier bank shares or equities via an online stockbroker.

This is a point you need to understand. Doing so requires me to get back to basics.

Almost all businesses are made up of debt and equity. If you start a new business, you own that business and are the sole shareholder in it. That is your equity. But you might also borrow money from the bank, which is your debt. When a business fails, the shareholders bear most of the risk - they get their money last.

The same principle applies to a home. When you buy a house, you put in cash via a deposit. That is your equity. But you also typically take out a large loan from the bank. When your home's value rises and falls, so does the value of your equity. In contrast, the bank's return is the comparatively secure interest rate on its loan to you.

If you have to sell your house, the bank is paid in full - the equity is whatever is left over, if anything.

Now that you understand this, why shouldn't you be allowed to get access to the lower-risk returns associated with many high-quality bonds?

It's easy for you to buy shares in Westpac but near-impossible to invest in Westpac's AAA-rated covered bonds.

ANZ did retail investors a service by listing one of its bonds on the ASX recently (CBA has done something similar before). Because it is listed, you can buy and sell small parcels of it while getting an attractive 7.1 per cent a year return.

Buying an ANZ bond means you rank ahead of ANZ's shareholders. It's funny to think about it this way but when you invest in a bank's bonds, you are actually being a "bank to the bank". You are lending to the bank.

Another option is to invest in a fund or trust managed by professionals who specialise in investing in bonds. You can usually access these funds through a financial adviser.

This is going to be a big topic in the years ahead because retirees, near-retirees and even people in the "accumulation" phase of their lives need an alternative to our current bipolar investment world: you either get low-returning bank accounts or the high risk of shares. We need more middle ground.

Super funds have not been helpful in solving this problem. Before the recent crisis, the average "default" super fund was putting about 60 per cent to 70 per cent of your money into listed shares. You were being loaded up with risks you didn't need to take to meet your goals.

Get educated about bonds so you can save smarter.