Tuesday 28 October 2014 by FIIG Research Legacy

Bonds make sense in any market

Recently there have been a number of articles in the news regarding bond risk. This article is a brief summary in response to issues raised in the media

Generally these articles have referred to two potential risks:

  1. Interest rate risk that is the risk to bond prices as interest rates begin to move higher.
  2. Credit risk, the risk of investing in lower credit quality bonds with the aim of achieving a better return.

The aim of having an allocation to bonds is to incorporate the features and protections that bonds provide in times of market downturn in order to preserve capital and minimise volatility to the income generated from your portfolio.

While bond prices move up and down once they are issued and trading in the secondary market, assuming the company continues to operate, you will receive the face value (usually $100) back at maturity. As your bond moves closer to maturity it will drift back to face value which acts to minimise the price volatility. The chance of loss on investment grade bonds is very low.

Interest payments (known as coupons) on bonds are set at either a fixed rate, or in the case of floating rate bonds and inflation linked bonds, a fixed margin. They cannot be deferred and must be paid to bond holders. This protects the value and certainty of your income.

Those who invest in bonds indirectly via a managed fund, or in a listed hybrid, lose many of these features.

Investing through a managed fund means you only have a unit price for your holding, you no longer have the protection of a maturity date at which time you know the full face value will be paid back to you. Income is paid to the fund and the fund manager decides the interest payment paid as a distribution as the coupons are paid to the fund and not to you.

The managed fund’s unit price is subject to the cash flow needs of your fellow unit holders. It is calculated daily to reflect the value of the fund including any transactions and costs. So while you may be happy to hold your investment, if other investors want their money and the fund manager is required to sell assets, this will be reflected in the unit price and will impact the value of your investment. 

Hybrids do not offer the same protections as bonds. If you only hold listed hybrids, you not only lose the protection of a maturity date but coupons can be deferred and holders of new style hybrids can be bailed-in to equity or have the investment completely written off.

By investing in an investment grade, diversified, direct bond portfolio, you retain all of the protections of bonds with the added benefit of complete transparency and control over your fixed income investments. Bonds are one of the few investments that can look forward to show exactly what your earnings will be, through your coupon payments and final maturity payment.

By incorporating a mix of fixed rate, floating rate and inflation linked bonds you can minimise the impact on your portfolio whatever future interest view emerges rather than try to anticipate future interest rate moves.

This is exactly what you want your fixed income allocation to provide for your investment portfolio. Both capital preservation and income stability, both of increasing importance as you transition to retirement.