Last week we published Myths #1 and #2 which covered adding bonds as a portfolio exposure and why it’s fine to invest when interest rates or inflation is rising.
Myth #3. Bonds are too risky
Reality #3 Comparing like for like, in the same company, bonds are less risky than shares.
Legendary investor Benjamin Graham 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 Graham'’s recommended level, with around 1% in bonds. This is in stark contrast to investors in the US, UK and Europe who hold much higher allocations.
Below is a table showing the pension fund allocation to bonds in selected OECD countries. Australia is a dismal 4th lowest.
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 first and these investors would typically need to 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 are expected to deliver growth and higher returns than bonds but they are the highest risk investment in the capital structure and returns (either from capital appreciation or from dividends) are uncertain.
In contrast, fixed income securities sit higher in the structure, are safer in the event of wind-up or liquidation and are designed to deliver a known return. These characteristics means that 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.
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.
Myth #4 Fixed Income returns are low and will be a drag on my portfolio’s performance
Reality #4 Fixed income returns over the last ~35 years to March 2024 have returned 6.73%, while shares have returned 9%, a difference of just 2.28% - not what you would expect for much lower risk bonds.
FIIG clients have just received their returns for the FY2023-24 and the median portfolio return was 9.51%.
Bonds are considered lower risk investments than shares and therefore should not expect to generate comparable returns.
Until recently when interest rates have returned to ranges near their long-term averages, bonds have consistently returned 1-2% more than cash and in many cases much more.
The long-term chart for the period under consideration shows how consistent bond returns are through the cycle, whereas equity investments are volatile and prone to bouts of excess and despair, often returning periodically to the bond return line despite being higher risk.
In stressed markets, the bonds outperformed and had you held them in your portfolio, they would have helped smooth overall returns.
While you would expect lower returns for lower risk, investing in fixed income doesn’t mean it will be a drag on your portfolio’s performance.
Those investors that are prepared to trade their bonds would expect higher returns than the index return shown in the chart, as evidenced by FIIG client returns in the past 12 months.
Myth #5. Managed funds are better than investing direct - in bonds
Reality #5. Managed funds are neither better nor worse than investing directly in bonds. They are simply a different way to access the market.
If you invest direct, you have control over which companies you invest in, when you buy and sell bonds that may influence tax, the benefit of knowing when interest will be paid to you and how much will be paid. You can also take advantage of the natural maturity of bonds to have capital returned to you.
Traditionally, the over-the-counter Australian bond market operated in minimum transaction sizes of $500,000 per bond, making the market inaccessible to smaller investors. While $500,000 is still the standard sized transaction, FIIG Securities opened up the market in 2010 when it broke down the $500,000 bonds into smaller parcels.
Retail and wholesale investors can now invest in the over the counter, institutional bond market from $10,000 per bond with a minimum upfront investment of $50,000.
If you invest direct, you have control over which companies you invest in, when you buy and sell bonds that may influence tax, the benefit of knowing when interest will be paid to you and how much will be paid. You can also take advantage of the natural maturity of bonds to have capital returned to you.
Managed funds certainly have their place. FIIG itself operates a managed fund called the FIIG Australian Bond Fund, with a low $10,000 minimum investment and a target return of over 5.25% p.a.
Funds trade control and transparency for professional management, typically greater diversification and ease of reporting. They also charge an all-in management fee rather than a spread per transaction and a custody fee.
A middle ground between a managed fund and a direct bond portfolio is FIIG’s Managed Discretionary Account, where investors give decision making over individual security selection to an experienced FIIG manager while retaining full transparency over the portfolio and any transactions.
Many investors mistakenly think hybrids, more often traded on the ASX, offer similar protection to bonds but they are far more complex and considerably riskier.
Whatever your preferred mode of investing in bonds, be it with full control and transparency or no control but an easy solution run by professional managers or somewhere in between, FIIG has a solution to allow you to access this important market.