Tuesday 21 November 2017 by Elizabeth Moran Opinion

Make the differences between bonds and shares work for you

Qantas is this year’s ASX 50 top performer, while Telstra earns the wooden spoon. This note explores the time to invest in shares and the time to invest in bonds

earthandmars

Many mum and dad shareholders focus on the largest ASX companies and hold significant allocations to them. Similarly, bond investors just starting out, or whose specific goal is to preserve capital, have a preference for companies that they know and are listed say, in the ASX Top 50.

The companies usually are large enough and have a long enough history to provide confidence that they will still be around when the bond is due to mature and repay $100 face value as well as make interest payments along the way.

It may surprise some of you to know that 40 of the Top 50 ASX companies issue bonds. Very few are available to retail investors in the ASX listed market. Most are only available in the over the counter market and some companies such as Westfield and Rio Tinto only issue in foreign currencies.

Not all appreciate that bonds are lower risk than shares in the same company or the fact that credit ratings refer to the company’s bonds and that the shares cannot be rated as they are perpetual and never have to be repaid.

Lower risk should mean lower returns and equally higher risk, should mean higher returns, but does that mean investors should always prefer shares?

The same but different – embrace the differences 

There’s a time for investing in the shares and a time for investing in the bonds of any given company. If a company is growing strongly, then to maximise returns, you would want to be invested in the shares. The unlimited growth potential is going to be more attractive than a lower risk, certain income and the possibility of limited higher capital prices you get with the bonds.

The opposite is also true.  Companies that are finding growth elusive and may be going through trying economic times are not going to make great share investments. This is when you are better off investing in the bonds. That way, income is reliable when the dividends may be cut and capital is preserved when the share price could plummet.

Over the last year, Qantas has been the stand out Top 50 ASX performer, with the shares rising from $3.15 on 16 November 2016 to $5.98 last week. That’s a whopping 91% improvement, an impressive gain.

But not so long ago, it was a different story. Qantas failed to pay a dividend for many years. It was a consistent underperformer from 2010 until 2015 when the share price peaked at just over $3 and hit a low in June 2012 of $1.03. In fact, for three of those years, the price was below $2 a share. This was the right time to switch into the bonds. Qantas issued a bond in April 2013 paying a fixed rate of 6.5% per annum and another in May 2014 paying 7.75%. These were good returns at the time if you thought the company would continue to operate.

The same bonds have risen in price to circa $108 and $118 respectively, so those that invested at first issue could now sell and make higher than expected returns.

Current yield to maturity on the four Qantas bonds range from 2.82 to 3.94 per cent per annum. The question becomes the growth potential from here for the shares versus the certainty of a positive return and the preservation of capital for the bonds. It’s a matter of understanding your risk appetite and tolerance for loss.

At the other end of the ASX Top 50, is Telstra. It has been the worst performer over the last 12 months, with its shares declining by 28 per cent from $4.84 to $3.43. Further, Telstra have flagged a reduced dividend payout ratio. Ouch!

Telstra bondholders have been considerably better off. Telstra has an Australian dollar denominated bond maturing in July 2020, that was priced around $117 a year ago, that has declined in price by just 3.5 per cent to $113. Bonds are less volatile than shares, a significant benefit if you think markets are looking expensive.

The bond was issued years ago with a fixed interest rate of 7.75 per cent per annum. Even though the shares have tumbled, Telstra bonds remain a low risk investment and current yield to maturity on the bonds is about 2.5 per cent per annum, which would be attractive to those wanting a very low risk defensive investment.

When trying to decide whether to invest in the Telstra shares or the bonds, investors should ask themselves - will Telstra grow in the coming year and see its share price rise? Is the yield to maturity of 2.5 per cent per annum enough compensation to invest in the bond?

I think ‘growth’ is harder to qualify than ‘survivability’. Not that long ago, Telstra was the share market darling. Many of Australia’s largest companies are mature business and if they have a question mark over future growth prospects, the bonds may be worth a second look.

Note: Prices accurate as at 17 November but subject to change


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