We wrote an article back in February attempting to answer the question of what to do about falling term deposit (TD) yields – the link is here.
Given TD rates have now fallen even further, to around 0.40% on average for a 1-year major bank deposit, this question has taken on even more relevance.
Clearly SMSF trustees are still holding onto the relative safety of cash – the ATO statistics show that the allocation of SMSFs to cash and TDs has declined only gradually from around 26% to 22% of assets since June 2018, over which period the average 1 year term deposit rate has declined from 2.20% to today’s 0.40%.
Looking at our sample portfolios over the same period, the Conservative portfolio (all AUD, all investment grade – the lowest risk offering) has reduced from a yield of approximately 3.9% p.a. in June 2018 to 3.13% p.a. today.
This means that two years ago, the bond portfolio returned approximately 1.77x the TD rate, yet today this equivalent figure is an astonishing 7.83x the TD rate.
So, the relative value of investment grade bonds has increased over the last two years by nearly 4.5 times, and yet the allocation to debt securities by SMSF trustees has remained constant at 1.5% of portfolios.
So clearly there is a slow shift of assets away from cash over the period, but not to bonds, which are the next lowest risk asset on the spectrum. This makes no sense.
Anecdotally, given the rise in funds under advice of passive exchange-traded-fund (ETF) structures, it would seem likely that equity income vehicles have been the likely choice.
The folly of this approach has been proven in the last 9 months, with most of the major dividend payers, such as the major banks and Telstra, all having cut their dividends significantly.
So what is (part of) the answer? How do you maintain or increase your income without taking all the risk of equity capital price and dividend volatility?
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The answer (once more) is investment grade bonds
Over the last 30 years or so, the bond market in Australia (which is mainly government and investment grade corporate [financial and non-financial] bonds) has returned approximately 2% per annum more than cash, as the hopefully familiar chart below shows.
This is the extra return you get paid for taking the credit risk (the risk you don’t get paid your interest on the due date and don’t get your capital back at maturity) of the corporate issuer compared to a term deposit in a bank.
The returns shown in the chart are generated from investing $10,000 on the 1st of January 1990 to the 30th of September 2020 (the latest available data from Vanguard). Over the period, bonds have returned 2.56% per annum more than cash, and typically at any point in the cycle this excess return is between 1.5-2.5% per annum.
Approximately 90% of the current bond index is government risk – either the Commonwealth, States/Territories or foreign government sponsored organisations such as the World Bank – so very little if any credit risk.
This is why we focus on investment grade bonds – for their safety.
I recently wrote an article about using credit ratings to evaluate risk, which can be viewed here.
Despite the pandemic, in 2020 no investment grade rated issuer has defaulted globally. Over the 40 year course of the S&P study, the historical default rate for all investment grade bonds for any given 5 year period is just 0.88% - which means that on average 99.2% of the time you get paid 100% of what you were expecting.
In Australia, the record is even better, with only 3 investment grade bonds having defaulted in this period – HIH Insurance (fraud), Pasminco (over-leveraged zinc smelter) and Babcock & Brown (GFC victim). In every single other bond, every single interest and capital payment has been made on the due date.
With TD rates now plumbing all time lows, and yet bond yields having held up remarkably well, the relative value of investment grade bonds over TDs (acknowledging that bonds are riskier and are not a direct equivalent) has not been greater, perhaps ever.
Now is the time to take the step into the next obvious asset along the risk curve - increase or maintain your income and add bonds to your portfolio.