Wednesday 24 October 2018 by FIIG Securities FIIG Securities Education (basics),Opinion

Busting the seven key myths about bonds Myth #1. My portfolio consists of shares and I don’t need a bond exposure

Over the last 20 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 misconceptions 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.

facsts myths

Reality #1 Bonds protect your portfolio in ways that shares and cash do not.

Here are eight reasons why:

  1. 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 no firm expectation of capital being returned.

Bond investors rank higher up the capital structure and must be repaid 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.

Simplified bank capital structure diagramMyth busting chart 1

2. Generally, the performance of shares and fixed rate bonds are not correlated. This means that a portfolio of fixed rate bonds will act to reduce the overall volatility of a portfolio. In the graph below, note how much greater volatility shares (dark blue line) have compared to bonds (light blue line). Despite the significantly higher volatility of the shares and higher risk, there is little separating average annual returns after 20 years with shares returning 11.88%pa and bonds 11.24%pa.

Annual asset class return – Shares versus Fixed rate bonds

Myth busting chart 2

Source: Bloomberg/ FIIG Securities

3. 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.

4. Bonds are liquid and can usually be sold on similar basis to shares (Trade +2 days). While most banks will allow access to term deposit funds in case of emergency, you will usually forego interest whereas you will receive interest on the bond up to the point of trade.

5. Floating rate bonds that are linked to a benchmark such as the bank bill swap rate (BBSW) will see interest payments rise when the benchmark rises, ensuring investors are compensated in a rising interest rate environment.

6. 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.

7.Bonds offer a way to invest in foreign currency and earn a higher rate of interest compared to deposits in the domestic currency.

8. Inflation linked bonds provide a direct, 100% hedge against inflation, issued by governments and corporations. These are typically very long dated securities. There are Treasury indexed bonds on issue that mature in 2050.

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.

If you would like to learn more about bonds, see our events page on the FIIG website.