Eye on bonds to diversify investors' portfolios
The Australian economy has experienced robust growth in recent decades and has now slowed. Inflation and wages growth is low, which has helped to push up bond values in recent years.
The Australian economy has experienced robust growth in recent decades and has now slowed. Inflation and wages growth is low, which has helped to push up bond values in recent years.
Many investors have missed out on the bond rally because their portfolios have been long on equities and short on bonds.
Many Australian investors' portfolios are heavily exposed to equities and other growth assets such as property. Most don't realise just how risky their asset allocations are.
One way of significantly reducing this investment risk is to diversify into bonds, which offer several attractions.
Bonds are considered defensive investments because they tend to do relatively well when share markets correct. In times of economic downturn or financial market instability, investors typically switch out of equities to bonds, especially government bonds, because of bonds' relatively stable returns.
The graph below shows the strong outperformance of Australian bonds during the GFC compared to equities.
The second chart displays the greater capital stability of bonds compared to equities. Over 10 years to 30 June 2017, the return on bonds easily outstripped the return on the S&P/ASX 200 Accumulation Index, which returned 3.30 per cent.
Floating rate bonds, otherwise known as "floating rate notes" or "FRNs," using the benchmark Bloomberg AusBond FRN Credit 0+ Yr Index as a guide, returned 4.37 per cent while corporate bonds did even better, with the benchmark Bloomberg AusBond Credit 0+ Yr Index, returning 6.36 per cent over the same 10-year period.
So, bonds did a lot better than Australian equities, which dived during the GFC and took almost six years to recover. Bonds withstood the assault and came out post the GFC performing much better.
That's why they are so important to include in a well-diversified portfolio.
Bonds also provide essential income for investors and can be an effective substitute for cash.
The fact is, many Australian investors are holding too much cash in their portfolios and in doing so are not taking advantage of higher returns available from fixed-income assets.
SMSFs, for example, hold almost one-quarter of their portfolios in cash and term deposits. Many of these investments yield 2 per cent or less per annum.
FRNs, a type of corporate bond, are an effective substitute for cash investments as they offer relative capital stability when compared to equities and higher yields than cash. That's because their coupon interest rate is "floating" and resets every quarter, so their coupons track the bank bill swap rate (BBSW), which rises (and falls) with official interest rates.
For example, a FRN may be issued with a face value of $100 for three years with a coupon of "3-month BBSW + 1 per cent".
Concerns about rising interest rates have prompted many investors to consider moving out of longer-term bonds, where duration risk is greater, and into FRNs.
You can access FRNs through ETFs, which usually entail significantly lower costs than managed funds and therefore the potential for superior returns.
Moving slightly up the risk spectrum, investors can earn an even higher income return while still enjoying a relatively stable capital return by investing in corporate bonds which are also available through ETFs.
Corporate bonds offer investors a regular reliable income stream and some peace of mind that their capital will be able to weather a downturn better than a portfolio of blue-chip shares dominated by banks and miners.
At the very least, a well-diversified portfolio should include good credit quality bonds which can withstand the ups and downs of financial markets and give investors some peace of mind that their portfolio is defensively positioned against share-market volatility.
More from Morningstar
• Make better investment decisions with Morningstar Premium | Free 4-week trial
Russel Chesler is the director of investments at VanEck Australia. Established in 1955, VanEck is one of the world's largest ETF providers. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind.
© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.