Tuesday 02 December 2014 by Craig Swanger Opinion

Investing for yield - When to pick the equities and when to pick the bonds

For investors seeking regular, reliable, secure income without too much capital risk, bonds are the typical choice as they involve less capital and income risk than equities. Because bond interest must be paid by companies before any dividends are paid, they are by definition less risky than the equities of that same company. Volatility in price is also considerably lower for bonds over equities

But often equities might make more sense, particularly where there is a strong likelihood of upside in the share price. 

The benefit of being an SMSF investor is that you can in fact choose whether to use the bonds or the equities for a large number of Australian companies.  The exercise required is a simple four step process[1]:

  1. What is the universe of companies that you are interesting in?
  2. What is difference between the dividend yield and the bond yield for that company?
  3. Is there enough upside potential in the share price to justify both the risk of the downside and the difference in the yield?
  4. Combine the equities and bonds in the universe of companies so as to create the best combination of reliable income and capital stability.

6% p.a. portfolio: Illustrative combination of equities and bonds of various ASX companies

Table 1 below shows 10 examples of well known Australian companies with both equities listed on the ASX and bonds available to SMSFs.  The table shows whether the equities or bonds offer the higher yield, and this varies from company to company.  Security of capital is consistently better for bonds than equities, for the reasons above, and conversely the capital upside is far greater for equities over bonds.

The great advantage of the SMSF investor is that they are not constrained by asset class or other artificial boundaries.  They can choose to invest in a company in a way that suits their view of that company – where they are bullish on share price growth prospects, they can invest in the equities; and where they just want income, they can invest in the bonds. 

Table 1: Comparison of equities and bonds of selected Australian companies
comparison of equities and bonds of selected australian companies

Table 2: Income portfolio comparisonsincome portfolio comparisons

As shown in Table 2, blending equities and bonds can create slightly higher income than a 100% bonds portfolio. This decision would be suitable where an investor believes that there is sufficient upside in some of those companies’ share prices to justify the additional capital security risk.

The reality for many investors is that they are in fact shifting from equities to bonds as they choose to invest more conservatively, for example as they head for retirement. Where an investor is already comfortable with a company and holding the equities, choosing whether to shift from that company’s equities to their bonds is a simple way to lower overall risk, increase income or both.

In next week’s Wire, we will look at some specific examples of companies that may struggle to justify significantly higher share prices but that have steady cashflows, and therefore make for good value bonds.

All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities. Please note the majority of the bonds discussed above are available to wholesale investors only.

[1] While this approach seems at odds with the oft-followed asset allocation approach, it actually isn’t.  The exercise allows investors to create a balanced investment portfolio with the desired income without taking excessive share price volatility risk.  The portfolio can be balanced to achieve an overall asset allocation approach.

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