Investments

The benefits of bonds

December 2016

They’re largely safe, reliable, flexible and more straightforward than you may think.

You may be overlooking one of the most versatile and accessible investments, explains Jason Murphy.

Bonds – despite being a giant multi-trillion dollar market – are not widely understood. They can be simple, but come with jargon and terminology that give the impression they are exclusive, which often turns investors off.

That is a shame because with the sharemarket volatility and low interest rates that have characterised 2016, many investors could benefit from having bonds in their investment portfolio.

Robert Mead, head of portfolio management at investment firm PIMCO Australia, says bonds have historically been an “exclusive” option for sophisticated investors.

“But they shouldn’t be. They are quite straightforward.”

So what is a bond?

A government or company wants to borrow money. Instead of going to a bank, it sells bonds directly. By buying them, you lend money to the government or company.

The bond promises the investor a payment each year, and to return the value of the bond when it finishes. For example, a bond might cost $100, pay back $3 each year for five years, and then return $100 to the investor after five years.

Bond issuers make regular payments to their investors. These are generally lower than dividends from shares and lack the tax deductions that come with some dividends. But they are predictable. So long as the organisation doesn’t go broke, it will pay the investor each year, and pay back the value of the bond at the end.

Government bonds are generally rated as more secure than corporate bonds as national governments rarely go broke. (Although, as Greek bondholders have learned, it is not impossible.)

Bonds bought from companies tend to be more risky than bonds bought from governments. They tend to fluctuate in value, and if the issuer goes under, an investor may lose some or all of their investment.

But corporate bondholders have an advantage over shareholders: if the company does go under – they will generally be paid some amount before shareholders when company assets are being divided up, but will still rank behind secured creditors.

Bonds v other fixed-income investments

Bonds can deliver higher returns than money in the bank. But they come with more upside than just the yield. Bonds can be bought and sold, and sometimes appreciate in value, meaning extra benefits for bond investors. On the downside, they can also reduce in value, meaning that if you want to sell before maturity, you may not get all of your money back. And if the issuer goes under, an investor may lose some or all of their investment.

“The biggest mistake investors make is to confuse yield for return,” says Mead, referring to the annual payment and the total benefit. “It is easy to say bonds are expensive because yields are low … but returns can be well above the yield.”

The annual return (“yield”) of bonds is higher when their prices are lower, and the yield is lower when prices are higher.

Bonds balance portfolios

Bonds are generally safer than many other asset classes, though there’s quite a range of risk profiles in the bond universe, and as in any investment, your money is at risk. They are commonly regarded as less risky than shares, being a medium-risk option for investors seeking a diversified portfolio.

Australian investors have a long-standing love affair with shares and especially property, which makes their investment portfolios more aggressive than similar investors in other countries, says Mead.

“Many Australians have a real ‘barbell’ between things like shares and cash and leave out the big opportunity in the middle.”

As investors grow older, generally their need for predictable cash flow increases and their appetite for risk decreases. Bonds tend to have less volatility than stocks because the bulk of their return comes from consistent interest payments, not price rises.

Perhaps the key point when considering the role of bonds in your investments is that they can help manage risk in a portfolio.

ANZ senior manager, investment management, Peter Jones, explains bonds as the “ballast” portion of your portfolio, designed to help prevent the ship from tipping too much.

Price

The role bonds play in diversifying an investment portfolio is especially important because of how bonds react to events in the market.

Like shares, bonds are tradeable. An investor can buy a bond and instead of owning it until maturity (when it pays back the face value), they may sell it in the open market.

The regular payment promised doesn’t change even though the market value does. This creates an interesting effect. Imagine a $100 bond that pays $3. That gives a return of 3 per cent a year. If that bond falls in price to $50 in the market, you can buy it and still get paid $3 a year – a return of 6 per cent. Provided that the issuer remains solvent, you would still be entitled to receive the $100 face value at maturity.

This matters because bonds become popular when shares fall in price. When one goes up, the other generally goes down. In other terms, the correlation of price movements between stocks and bonds is low, or even negative, according to PIMCO.

In the years since the end of the global financial crisis, for example, the price of bonds hit unforeseen highs. They kept paying out the same amount per year so yields shrank to record lows.

Risk

Conversely, in the current period of low interest rates and low yields there is higher risk for those holding bonds. But there are general risks investors should also be aware of.

  • If official interest rates were to rise sharply (as may happen if economies strengthen), demand for bonds could fall and their price could fall too. This happened to some extent, with bond yields rising as investors recovered from their shock of Donald Trump’s win of the US election and took a favourable view of how his policies may impact the US economy.
  • As inflation rises it erodes the value of income from bonds, as well as the principal that is repaid on maturity. Inversely, if inflation falls the bond should rise in price.
  • Reinvesting in bonds can become a case of diminishing returns. If an investor is receiving say a 10 per cent return on their bond investment, as market rates fall any reinvestment of bond proceeds will be at that lower rate.
  • There are some bonds that can be “called back” for their issuer to buy, whether the bondholder wants to sell or not. This is often done when interest rates have fallen and the issuer can obtain the funding cheaper elsewhere.
  • In cases of default, investors may not receive the interest they’re due or even the return of their capital investment. While national governments are often considered safe, they’re not always. And smaller organisations such as new companies can have a higher risk profile. Ratings agencies give credit ratings to bond issues and investors should research who they are investing in, and the terms of the offer, similarly to what they would with other investment classes.