Wednesday 19 November 2014 by Elizabeth Moran Education (basics)

Busting the seven key myths about bonds - Part 3

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 #3 Bonds are too risky

Reality #3 Comparing like for like, in the same company, bonds are less risky than shares.

Famous investor Warren Buffett once commented that investors should never have more than 75% shares in their portfolio and never less than 25% bonds and they should also never own more than 75% bonds and never less than 25% shares.

Australian SMSFs, however, do not hold even close to Buffet’s recommended level, with less than 1% in bonds. This is in stark contrast to investors in the US, UK and Europe who hold much higher allocations. Much of the reason for this is a lack of understanding of the fundamental truth about bonds versus shares: the two different asset classes complement each other.

Bonds are lower risk than shares in the same company and help to protect your capital. The reason is that if a company gets into trouble and is wound up, there is a legal structure dictating how cash and the proceeds of asset sales are applied.

In the event of wind-up or liquidation, funds are paid to the most senior investors in the capital structure (senior secured debt) first and these investors must be repaid in full before any funds are paid to investors on the next level. Then each level must be repaid in full before funds are paid to the next level (see the diagram below).

The position of your investment in the capital structure is crucial in determining its risk and whether the return you are receiving is enough.

Shares should deliver growth and higher returns than bonds but they are the highest risk investment in the capital structure. In contrast, fixed income securities sit higher in the structure and are safer in the event of wind-up or liquidation. Generally they are lower risk and offer lower returns than shares.

Including bonds and other fixed income securities in your portfolios should lower risk and volatility and help smooth returns.

Simplified Bank Capital Structure

simplified bank capital structure diagram

Source: FIIG Securities

So, if your portfolio is just shares and deposits, you’re missing out on all of the other rungs in the capital structure and the benefits of those investments.