The recent pandemic driven market turbulence has led to more interest in fixed income from private clients. This is mainly driven by an increase in investment diversification requirements as well as the desire for regular income. There are a number of questions we hear frequently as clients start to mull over the decision to invest in bonds. Here we take a look at a handful of such questions.
Why should I consider buying bonds now especially when yields keep trending lower?
Australians have an under allocation to fixed income securities when compared to other developed countries. Years of preferential tax treatment in other asset classes such as franking credits for shares and negative gearing for property has led to a higher allocation to these assets over fixed income.
The purpose of investing in bonds, even when yields are lower, is to diversify your investment portfolio. Bonds are a great diversifier. They can help protect your wealth and income throughout different stages of the economic cycle, while generally providing better returns than other alternatives.
Over the years we’ve continually recommended that portfolios should not be 100% invested in a single asset class, let alone a single venture. Finding a balance is important – a “no risk” strategy has its own problems as it could mean low returns and may not deliver enough income to live.
Interestingly, a fall in yields has led to capital price appreciation on many bonds allowing investors to exit their bond holdings at a profit.
Can I sell my bonds before maturity?
Yes, you definitely can. There is a very deep and active secondary bond trading market. Many investors actively trade bonds, similar to equities. Reasons for selling a bond prior to maturity include profit taking, portfolio reallocation, or cash generation to reinvest in a better opportunity.
When you purchase a bond, the yield on it is quoted to maturity, however if a bond rallies (price appreciates) significantly prior to maturity then selling the bond may be an option worth considering as the actual return on this bond will be higher than what the yield to maturity was at purchase.
For example, if you bought a 4-year maturity 3% fixed coupon bond 2 years ago at par ($100), the yield to maturity on this bond would be close to 3%. If the bond price has now moved to $105, the yield to maturity for the remainder of the bond’s life is 0.5%. In this case if you sell the bond at $105, your actual realised return is approximately 5.5%. You will still earn the 3% yield to maturity if you continue holding the bond till maturity when it is redeemed at par.
Isn’t it too risky to invest in high yield (HY) bonds in the current environment?
Just like diversification with your overall investments, it is important to have diversification within your bond portfolio too. The fact that HY bonds are inherently riskier than investment grade (IG) bonds is absolutely true, however these bonds also offer higher coupons and yields for that exact reason.
Allocating a portion of your bond portfolio to HY bonds can help improve the overall income generated by the portfolio. However, it is important to weigh up the risks and rewards of any investment to ensure they fit within your risk tolerance.
More and more companies are cutting dividends. Does that mean my bonds won’t pay their coupons?
Now, more than ever before, we are seeing a rise in dividends being cancelled or cut. This strategy is being employed by companies to improve capital and maintain cash given the heightened level of uncertainty created by the COVID-19 pandemic.
Equities rank the lowest in a company’s capital structure and hence the distribution on these is at the company’s Board’s discretion. However, bondholders (as creditors to the company) have a higher ranking charge on the company. The coupons on a bond are mandatory and are an obligation of a company. There may be cases where a company requests coupon deferrals but in such a case the coupon capitalises and interest accrues on it. As such, by the time of maturity of this bond clients recoup all the cashflow that is owed to them.
Call us with your questions
Please ensure you contact us with any burning questions regarding how to begin your bond investment journey. We are here to help.