Thursday 05 November 2020 by FIIG Securities facsts-myths Education (basics)

Busting the seven key myths about bonds Myth #2. Bonds are too risky

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.

Last week we published Myth #2 ‘It’s a bad idea to invest in bonds when interest rates or inflation are rising.

Reality #3 Comparing like for like, in the same company, bonds are less risky than shares.

Famous 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. 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 hybrids and 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 (senior secured debt) 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.

Myths 3 image The wire

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.

For more information please call Client Services on 1800 81 81 01.