Where an investment sits in the capital structure is crucial in determining whether the return adequately compensates the investor for the risk involved. Equities (or shares) are the highest risk and should provide the greatest returns. In contrast, most debt securities (with the exception of a very small number of hybrid securities) all sit higher in the structure and are safer in the event of liquidation (see Figure 1 below). Bonds can be either senior secured debt, senior debt or subordinated debt. Generally they are lower risk and offer lower returns. Including debt securities in investment portfolios lowers volatility.
Figure 1
Risk has a direct relationship with reward. The higher the risk of a security the greater the expected reward. Investing a high proportion of your funds in the highest risk category, equities (shares) can expose your portfolio to loss in a cyclical downturn. Fixed income securities which are lower risk as they sit higher in the capital structure generally lower the risk of a portfolio, helping to preserve capital. See Figure 2 below.
Figure 2
While government bonds earn relatively low returns they are very low risk, especially Australian Commonwealth Government bonds as the Federal Government has the ability to raise taxes and print money. In Australia, these bonds are considered “risk free” and the returns on these bonds are indicative of the “risk free” return.
Other investments must provide a return over and above the risk free rate, to compensate the investor for the higher risk they are taking, that is the increased chance of loss.