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Wednesday 03 July 2024 by Jonathan Sheridan

Busting the seven key myths about bonds - Part One

Over the last 25 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, some 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, property and cash and I don’t need a bond exposure

Reality #1 Bonds protect your portfolio in ways that risk assets 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 paid 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 have negative correlation meaning when shares underperform, bonds outperform and vice versa. In recent times however this negative correlation has broken down a little for a couple of reasons.
  • First, as share markets have been dominated by growth companies that are much more sensitive to interest rates than historically the share market can react negatively to anticipated rate hikes. Second, for much of the 2010s interest rates were exceptionally low, and bonds couldn’t rally far enough to balance the risk in equities. This risk has lessened now, of course.
  • However, generally this still means that an allocation to fixed rate bonds will act to reduce the overall volatility of a portfolio. In the graph below, note how much greater volatility shares (blue line) have compared to bonds (green 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.

  • 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 date +2 settlement). Banks require a minimum of 31 days’ notice to access a longer-term deposit and in any case 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 20 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.

Myth#2 It’s a bad idea to invest in bonds when interest rates or inflation are rising

Reality #2 There are three types of bonds best suited to different economic conditions.

Fixed rate bonds are most impacted by rising interest rates and inflation. Inflation linked bonds suffer from rising interest rates but benefit from rising inflation. Floating rate notes benefit from rising interest rates. The market’s expectation of future interest rate rises is already built into the current price of fixed rate bonds, so the prices are only impacted further if interest rates rise above expectations.

1. Markets are forward looking, so bond market prices have priced in expectations of future interest rate changes already

To assume that when the RBA or the US Fed increases interest rates, it is bad for fixed rate bondholders is not necessarily true, and actually more than often wrong. Markets are forward looking, including both share markets and bond markets. We’ve all seen shares that have announced a loss, yet the share price went up because the market was expecting a worse loss than announced.

Bond markets are the same – if rates rise, but rise less than expected, bond prices will go up, not down. It is a rise in interest rate expectations that is bad for bondholders, and a fall in interest rate expectations that is good.

As interest rate expectations fall when economic conditions surprise on the downside, the real question for bondholders is not whether rates are rising or falling (that’s already priced into bond prices), but whether the market is more likely to be surprised on the upside or the downside given economic conditions.

2. Only Fixed Rate bonds are directly impacted by a rise in interest rate expectations

There are three different types of bonds (fixed rate, floating rate and inflation linked) that work to protect your portfolio in various ways and are most effective under different market conditions.

Fixed rate bonds pay a fixed pre-determined rate of interest or coupon which is set at the time of issue and does not change during the life of the bond. These investments are ideal when the economy contracts (when property and shares usually underperform) and interest rate expectations move lower. The difference between fixed rate bonds and term deposits is that because the bonds are tradeable, their price moves. That can be positive, in that bond prices rise, or negative when they fall.

A floating rate note (FRN) pays a set margin over a variable benchmark and in Australia the benchmark is usually the bank bill swap rate (BBSW). The underlying benchmark rate will rise and fall over time based on prevailing interest rates. The margin over the benchmark is usually fixed and will be set at the time of issue.

Floating rate notes, because of the way they are structured, typically protect a portfolio when interest rates are rising. That is, as the Reserve Bank increases the cash rate to try and slow growth in the economy, FRN interest payments will also increase. Therefore, FRNs typically outperform fixed rate investments such as term deposits and fixed rate bonds when interest rates are moving higher. FRNs are also more capital stable than fixed rate bonds, in that the prices do not move up and down to the same extent.

Assuming a company survives, whatever happens to the price of a bond over its term, investors would still expect to be repaid the face value (the value at first issue) which in most cases is $100.

The third type of bond is the inflation linked bond (ILB) which are the only securities that provides a direct hedge against inflation. There are two types, both indexed to the Consumer Price Index (CPI):

  1. Capital indexed bond (CIB) This is the most common type of ILB, where variations in inflation during the life of the bond are reflected in the capital price, which results in “an adjusted capital price”. Interest payments are based on the capital value, so assuming inflation is positive, the indexed capital value will increase and the interest payments would also increase over the life of the bond.
  2. Indexed annuity bond (IAB) These bonds return both principal and interest at each preset payment date over the life of the bond until the maturity date, in contrast to the CIB where there is one lump sum at maturity.

Inflation linked bonds can be attractive in low interest rate markets. The bond prices can be lower than the value of the bonds or the yields can be higher than yields on similarly rated bonds with comparable maturity dates.

In summary, the three types of bonds work best in different economic conditions but for investors new to fixed income, we would recommend a portfolio allocation to all three although weighted depending on your interest rate outlook.