Diversifying your investment portfolio with bonds

Press/Media: Expert Comment


As the Financial Services Royal Commission (FSRC) continues to uncover misconduct in the banking, superannuation, and financial services industry, it is natural that many Australians both young and old are left asking themselves whom they can trust, and are taking a more pro-active role in their financial futures and superannuation investment decisions.

Although many of us are told to maximize the size of our retirement nest egg and are provided with lofty savings goals, the advice of Nobel Prize laureate, Robert Merton, is that investors and retirees should focus on generating a stable income source in their retirement. But how does one generate a stable income source given the complexity and volatility of financial markets?

Generating a stable income from our investments

Every investment (i.e., asset) class generates a return from two sources, that is the yield and capital gains. The yield of an investment is the return it generates over the life that you hold the investment, and capital gains (or losses) is the sale price minus the purchase price of the investment. For stocks, the yield is the dividend, for real estate it is the rent, and for bonds it is the coupon.

Each investment class has its own risks and benefits, and to maximize the benefits, one needs to follow a core tenet in finance , that is diversification. Diversification is key to protecting an investment portfolio from significant losses. At present, most Australians are heavily invested in the Australian stock market or investment properties that are both are significantly exposed to risks in the domestic economy. That is to say, if the Australia enters a financial crisis after its record-breaking 27-year economy expansion, stocks will drop and housing prices will fall, thus damaging the values of all investment portfolios.

Risks in the typical Australian investor’s portfolio: Stock Market & Real Estate.

Investing in the Australian stock market carries significant risks as around half of the market capitalization of the ASX is highly concentrated in both the Financial (30%) and Materials (18%) sectors. Thus, the findings and penalties imposed by the FSRC and any decrease in the global demand for Australian commodities has the potential to seriously dent superannuation portfolios.

Although the adage ‘safe as houses’ has held through in Australia for the last decade or so, experts believe that the Australian housing market is significantly overpriced. Investment in real estate significant risks such as interest rate risk (i.e., increases in interest rates leading to lower housing prices), regulatory risk (i.e., removal of negative gearing as a tax deduction), and liquidity risk (i.e., houses can take a significant period of time to sell).

Investing in corporate bonds

One of the major findings from the FSRC is to both encourage the growth of the Australian domestic corporate bond market and “encourage retail investors to consider diversifying their asset portfolio to fixed income products”.

Bonds are fixed income investments where investors are providing a loan to an entity (e.g., government or corporation) for a fixed period (e.g., 5 to 10 years or longer). As a simple example, BHP Billiton can issue bonds that each have a face value of AUD200k that have a 5% coupon payment that has a maturity of 10 years. An investor can purchase this bond and will receive AUD10k every year for the next 10 years. At the end of the 10 years, BHP Billiton will return the AUD200k back to the investor.
Thus, the coupon payment (i.e., AUD10k) from the bond is the yield on the investment (i.e., 5%), and at the end of the life of the bond (i.e., 10 year maturity) the face value (i.e., AUD200k) is returned back to the investor. As the coupon payment provided to the investor is usually at a ‘fixed’ percentage of the value of the bond, therefore these investments are classified as fixed income investments. Thus, an investor/pensioner can purchase a bond that has a coupon payment (i.e., income stream) that matches his/her monthly expenses. In this manner, a stable income stream is generated to ensure a comfortable retirement.

Although the concept of generating a stable income stream can be replicated using equities (i.e., investing in stocks that have high dividend yields) or real estate (i.e., purchasing houses that have high rents) bonds have several advantages as bond prices are not as volatile as shares, and they are more liquid than real estate investments (e.g., selling a property can take three months or longer).

Manging risk in bond investments

The primary risks of investing in corporate bonds are as follows:

  • Interest rate risk. Changes in the interest rates that are set by the central bank (i.e., Reserve Bank of Australia) can change the value of bonds. Generally, the value of a bond has an inverse relationship with interest rates such that an increase (decrease) in interest rates decrease (increases) the value of the bonds. This characteristic of bonds is similar to real estate, as housing prices drop when interest rates are high as mortgage repayments are more expensive. The advantage of bonds in this respect is that at the end of the maturity of the bond, the bond issuer (i.e., the entity that is loaning the funds provided by the investor) will return the ‘face value’ of the bond. Thus, although institutional investors often trade bonds and adjust their bond portfolio's duration for interest rate risk, it is not recommended that retail investors follow the same strategy. Retail investors should hold the bond to maturity and focus on receiving the coupon payments from the bond as an income. Such a strategy is similar to holding on to stocks that have high dividend payouts with the advantage of lower volatility

  • Credit risk. This is where the bond issuer (i.e., the entity that you purchased the bond from) does not make the coupon payment or return the face value of the bond to the investor at maturity. Intuitively, this means that the loan is not being paid back to the investor (i.e., default). In such situations, there is a legal process to recover a portion of what is owed to the investor from the bond issuer. To mitigate credit risk, investors can look for the third-party independent credit rating of the entity that is issuing the bond (i.e., AA or BB ratings) and read the prospectus of the entity to understand the entities business operations.

Why haven’t Australian investors been advised to diversify into corporate bonds and fixed income?

Investing in corporate bonds is not new, and the size of the global bond market is around USD100 trillion. In the US, the bond market is USD40 trillion whereas the stock market is less than USD20 trillion. With the exception of the US, the bond markets are undeveloped in many countries due to deliberate efforts to slow its development. Banks prefer that corporate entities finance their operations using short-term loans rather than the bond market as this allows for profit maximization since the banks generate fees by rolling over short-term loans. Furthermore, investment managers make money by trading superannuation assets and turning over stocks in an investment portfolio. Thus, if investors were invested in long-term investments such as bonds, this results in lower profits for banks and for investment managers.

Investing in the Australian corporate bond market

In the past, investing in corporate bonds were only available for high-net worth individuals as each bond investment requires a minimum of AUD200k, that is out of reach for most retail investors. More recently, several accessible options for investing in corporate bonds and fixed income are available.

Superannuation funds have investment options that include fixed income mutual funds. These are where fund managers invest in a large number of corporate bonds and pool together the coupons from each bond to provide a return back to superannuation clients. Investing in this manner has the advantage of diversifying across a set corporate bonds and will generate a lower, safer return.

Bond exchanges facilitate investment into bonds by retail investors by splitting a single bond issue into smaller components. For example, a AUD200k bond issue can be split into twenty components of 10k each which is more affordable and accessible by retail investors. Some firms that currently provide this service are the Australian Bond Exchange and FIIG.

To conclude, it is hoped that the actions of the FSRC will result in solutions to properly incentivize the financial sector to be fiduciaries and have interests that are in-line with clients rather than profit maximization. Investors should seek to educate themselves of the importance of diversification, and understanding the benefits of investing in fixed income assets and how to do so.

Period1 Oct 2018

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