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Wednesday 31 July 2024 by Jonathan Sheridan

Busting the seven key myths about bonds - Part Three

In our final article of the bond myths series we look at bond maturities and hybrids.

Myth #6. There is too long to wait until maturity

Reality #6 Once bonds are issued, they are traded in the secondary market. You can buy bonds that are close to maturity, say with one or two years to go. You don’t have to buy new issue bonds.

Bonds can be issued with very long terms to maturity. Some have 20, 30 or even 50 years until they mature, and capital is repaid to you. Don’t be put off by the long terms. Here is the list of reasons why:

  1. The over-the-counter bond market is huge and in 2023 the Securities Industry and Financial Markets Association (SIFMA) estimated that the global market was worth US$122.6 trillion, bigger than the global share market worth ~$111 trillion. SIFMA estimate the Australian dollar bond market is worth ~$2.45 trillion. This massive, global market trades very large volumes of bonds every business day. You can typically sell your bonds at short notice and access your funds.
  2. While you might think you may not be around to see some of the maturity dates available, we’re all living longer. Longevity risk is one of life’s great unknowns. One way to hedge against this risk is to invest in longer dated bonds, which will help protect you against running out of money. Just about everyone I know knows a healthy nonagenarian (someone aged 90 to 99 years)!
  3. Because bonds are tradeable you can buy them when they are close to maturity. If you don’t want to invest in anything greater than say two or three years, there are still many options available.
  4. Longer dated fixed rate bonds will show the greatest price movements when interest rates rise and fall. They are very protective in a declining rate environment, and so should be considered in certain economic circumstances.

Myth #7 I own hybrids so I already have an allocation to fixed income

Reality #7 Hybrids have traditionally been part debt and part equity. Since 1 January 2013 under new Basel III regulation, bank hybrid issues have become much more like equity, and do not provide the same level of protection as bank bonds in a downturn.

That’s why it’s important to own a range of fixed income investments including lower risk bonds that have more stable prices in a distressed market compared to hybrids.

Hybrids can miss paying interest and can have long terms until their first (and maybe subsequent) call dates.

Hybrid distributions can be missed and never paid to you, making investment in hybrids higher risk than deposits and bonds. If you are investing in hybrids for the income, then it’s important to be aware of this risk.

Most bank hybrids are perpetual, meaning they have no fixed maturity date and if not exchanged or redeemed, could remain on issue indefinitely. A requirement of bank and insurance regulators, such as APRA, is that these securities must be perpetual and must be able to absorb losses on an ongoing concern basis (that is, coupons can be foregone without payment and are non-cumulative) and at the point of non-viability (conversion into common equity or write-off), in order to qualify as regulatory capital.

Hybrids typically contain clauses with call or conversion dates before final maturity but there are usually conditions attached and the dates are by no means guaranteed with the power in the hands of the issuer.

On the other hand, bonds and deposits have known interest payment and maturity dates, which if not met are an event of default.

Hybrids have all of the downside risk of shares, without the upside. Bonds offer greater certainty you’ll be paid your interest and principal. Subordinated bank bonds are similar to hybrids and can also convert to shares in certain circumstances.

Our research shows that hybrids are much more volatile in price than bonds and are more likely to track the underlying share when markets are distressed as the graph below comparing three Commonwealth bank investments demonstrates.

The purpose of the graph is to show a worst-case scenario and the volatility the various investments showed during a crisis.

We invest $100 on the 2nd of June 2016 and then track performance throughout the COVID crisis. The dark blue is the equity, the green is the PERLS VIII hybrid and the light blue is a subordinated Tier 2 bond.

The returns shown include interest payments on bonds, distributions on the hybrids and dividend payments on shares, as well as franking credits.

The subordinated bond line shows a fairly gradual upward trend increasing in value. The crisis barely impacts its value, enabling investors to sell if needed and recoup their capital. The returns are stable and consistent, in fact boring, but in bond investment we think “boring is good” as it is what protects your portfolio.

The hybrid, being higher risk than the bond, shows increasing volatility. In the worst case scenario, an investor selling in March 2020, would have lost approximately 15% of their capital.

The shares show the most volatility as they are considered highest risk, falling over 40%. But notice how the hybrid declines like the share and loses 15% of its value. If your fixed income allocation is 100% hybrids, we think you are taking on too much risk in your portfolio and not providing enough of a hedge against your shares.

CBA is often considered as being the lowest risk company on the ASX. The other major banks are also low risk but if you only own bank hybrids, we’d expect all of them to perform in a similar fashion under stressed market conditions.

Managers of large investment funds know the best way to combat uncertainty and to protect capital and income is to diversify investments. Replacing some of your hybrids with lower risk bonds will help to lower the risk and improve diversification in your portfolio.