Monday 03 November 2014 by Elizabeth Moran Education (basics)

Busting the seven key myths about bonds - Part 1

Over the last 15 years, the FIIG team has had thousands of conversations with investors who are considering investing in bonds and other fixed income investments.

We’ve come to recognise some key concerns that investors quote when discussing a potential investment, most of which are based on false assumptions. So, if you’re still unsure about bonds, this series of articles which delves into the “Seven Key Myths” may help.

Myth #1 My portfolio consists of shares and cash and I don’t need a bond exposure

Reality #1 Bonds protect your portfolio in ways that shares and cash do not. Here’s why:

  • Bonds are lower risk investments than shares. They are a legal debt obligation of the entity issuing them and interest and principal must be paid according to the terms and conditions of that debt. In contrast, shares are higher risk as there is no obligation to pay dividends and never any commitment to return capital.

Bond investors rank higher up the capital structure and must be repaid in full before any funds at all are available to shareholders. Shareholders, being the lowest rung of the capital structure, bear losses first and this in part drives high levels of volatility.

  • Generally, the performance of shares and fixed rate bonds are not correlated meaning when shares underperform, bonds outperform and vice versa. This means that a portfolio of fixed rate bonds will act to reduce the overall volatility of a portfolio. In the graph below, note how much greater volatility shares (grey line) have compared to bonds (blue line). More importantly, the returns on bonds peak at the time share returns are negative. Including an allocation to fixed rate bonds in your portfolio will help smooth overall returns.

annual asset class return

  • Unlike deposits, bonds and other fixed income securities can earn higher than expected returns. Once bonds are issued, they begin to trade in the large, global secondary market. Bond prices go up and down and investors can achieve higher returns by selling their bonds prior to maturity for a higher price.
  • Bonds are liquid and can usually be sold on similar basis to shares (Trade +3 days). While most banks will allow access to term deposit funds in case of emergency you will usually forego interest.
  • Floating rate bonds that are linked to a benchmark such as the bank bill swap rate (BBSW), will see interest payments rise when interest rates are climbing, ensuring investors are compensated in a rising interest rate environment.
  • Bonds offer access to sectors of the economy not listed on the ASX for example governments, international banks and corporations and infrastructure assets such as Australian National University.
  • Bonds offer a way to invest in foreign currency but earn a higher rate of interest compared to investing directly in say, USD or Euros and holding the currency in a bank account.
  • Inflation linked bonds provide a direct, 100% hedge against inflation, for periods of up to 30 years.

If you have plans for your investments like retirement, a wedding or gifts to grandchildren to fund education, you need some certainty in your portfolio. Most bonds have a known maturity date and investments can be made so that maturities coincide with your plans.

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