article 3 months old

What Role Do Bonds Play In A Portfolio?

Australia | May 12 2021

FNArena's series on bond investment continues with further information and explanation

-Why buy a bond?
-What are the risks?
-What types of bonds are available?

By Mark Story

Given that bonds are by nature defensive assets, their role within your portfolio is first and foremost about the diversification they bring to your overall asset mix. Just like a fund manager will use hedges to minimise the downside for investors, you can deploy bonds to smooth out the volatility within a diverse asset mix, where each asset class is designed to perform a different function.

But remember, this strategy assumes you’re invested for a least three years, otherwise simply holding cash may be a preferred option.

Bonds provide income and capital preservation

Put simply, bonds have a different return profile to shares, and as such offer greater stability of returns. While risk assets like shares are typically bought for growth, the role of bonds is to generate income and preserve capital.

By doing that they help to offset any losses from the non-performing assets within your portfolio.

To understand why bonds can play this role, it’s important to know that as an asset class they’re what are referred to as ‘uncorrelated’ with equities. In other words, when equities perform well, bonds typically don’t. Hence, during a steep stock market decline, government bonds tend to appreciate, serving as a valuable offset for those losses.

It’s when large-blend stock funds are performing badly that government-bond funds are more likely to be in the money.

But it’s important to distinguish between government bonds and corporate bonds when it comes to the diversification they can bring to a portfolio. For example, government bonds tend to be the defensive of the two during market panic, due to having little to no default risk and being generally very actively traded.

As a result, prices can rise during market turmoil as investors seek safe havens. Government bond yields also tend to be directly wired to the state of the economy, and prices benefit if interest rates are cut. Given that government bonds tend to have longer holding periods, price and yield are more sensitive to changes in economic conditions.

Bonds can smooth out the bumps

While an experienced long-term investor may choose to ride out the ups and downs in the market, a well-diversified portfolio can help even out bumps on the way to reaching a desired goal. As a safe-haven asset class, bonds can also be relied upon as a hedge against economic slowdown.

While slower growth usually leads to lower inflation, this can make bond income appear more attractive. The income from bonds comes in the form of income payments and are typically paid quarterly, twice yearly or annually. These payments can be used to help supplement living expenses, or can be reinvested.

It’s true, shares also provide income in the form of dividends. However, dividend payments are less reliable than bond coupons, and since the pandemic many of those dividends have fallen away and are yet to return in full.

Bonds can offer capital appreciation

The other important role bonds can play is around the certainty they offer regarding the preservation and return of capital. Interestingly, while bonds aren’t typically bought for capital appreciation, this also is possible by taking advantage of rising bond prices by selling prior to maturity on the secondary market.

It’s during periods of stock market declines that bonds are most likely to gain in price. This strategy is often referred to asinvesting for total return’ and is popular with more experienced bond investors.

What are the risks of owning bonds?

While bonds are considered safer than other asset classes like shares and property, that doesn’t mean they’re entirely risk-free. Here are some of the key risks associated with bonds investors need to be aware of.

Inflation risk

One of the primary risks to bonds is inflation, which erodes the value of those fixed payouts and final pay-back of your investment. Simply put, this happens when the rate of return on a bond fails to match the percentage rise in the cost of goods and services, reflected in the consumer price index (CPI), the main measure of inflation.

In worst case scenarios, if your post-tax returns are lower than the rate of inflation, the value of your investment is falling, and it’s literally costing you money to invest in bonds.

Interest rate risk

Movements in the official cash rate set by the Reserve Bank of Australia (RBA), can have a material impact on the market value of bonds that are listed on a stock exchange. That’s because there’s an inverse relationship between bond yield and bond price.

When interest rates go up, the market value of bonds will generally go down. As a result, you would get less money for them if you chose to sell them before they matured. But if interest rates go down, then the market value of bonds would most likely rise because the coupon rate on the bond, while unchanged, would become higher in relative terms.

Higher durations usually mean the bond price is more likely to drop as interest rates rise. For example, a bond with a three-year duration will drop -3% as a result of a 1% increase in interest rates, since bond prices typically change by around 1% in the opposite direction to interest rates for every year of duration.

Market risk

Corporate bonds tend to share some of the same risks as the underlying stocks they’re issued against, and as such are highly correlated, meaning they both move in the same direction. As a result, if a company is threatening to go bust both the stock and the bonds of that company will fall in value.

Performance trends in the high-yield (often called junk bonds) market typically move in the same direction as the stock market, and the companies that issue these bonds are generally considered to be at higher risk of default.

Liquidity risk

Just as it is with equities, for every bond seller there needs to be someone who is willing to buy those bonds from you. If you decide to sell some bonds, you may not be able to find the buyer you want, hence you might be forced to accept a lower price.

Timing risk

Given that bond values fall when interest rates rise, timing can make a big difference in your payout if you’re thinking about selling. You might make a profit by selling a bond when interest rates are lower than when you first bought it.

But if you sell when interest rates are higher than at the time of your purchase, you’ll likely incur some loss.

Early redemption risk

If interest rates fall and the market price of the bond goes up, a corporate bond issuer may conclude the coupon on the bond is too high and choose to exercise its right to redeem the bonds early, if such a right is included in the bond contract.

Should the issuer buy the bonds back from you at face value, you could, if you bought the bonds on the secondary market, receive less than you paid for them.

The risk that stock and bond prices move together

The concept of the “balanced portfolio”, which includes both equity and fixed interest allocations, is based on the historical tendency of bond prices to move conversely to stock prices at any time, thus providing the “defensive” and “smoothing” benefits outlined above.

A standard balanced portfolio allocates 60% of funds to equity investment and 40% to fixed income (such as bonds) and cash.

However, it doesn’t always work.

The balanced portfolio is a creature of what we might call “normal” times, if we can nowadays assume there is such a thing. But over the past couple of decades we have experienced two very not-normal episodes – the GFC and the pandemic.

In both cases central banks slashed interest rates in order to prop up economies and give them time to recover from the shocks. Times of recession, or simple fear, encourage investors to buy government bonds as a safe haven, and lower central bank cash rates inspire investors to buy bonds for the yield they provide in a low yield world.

But the more buyers are attracted to bonds, the lower those yields will fall (prices increase).

The flipside is that low interest rates lead to higher stock (and property) valuations, as future earnings are discounted at a lower rate, and because companies can borrow cheaply to invest in growth, which is basically the point of lowering interest rates in the first place.

In such a situation, we see bond prices going up and stock prices going up.

Of course, if both asset classes in your “balanced” portfolio are rising in price, it can only be win-win. Until such time as it all reverses.

We saw early this year (2021) such an occurrence, when fears of rising inflation led to a sudden spike in US bond yields (prices falling). The assumption was that as the US economy improved, thanks to an effective bottomless pit of central bank monetary stimulus, the central bank will feel it no longer necessary to provide as much support, and indeed would need to wind back support to prevent inflation running too far, too fast.

The response was a big sell-off in the stock market in general, but also a pronounced rotation out of “growth” stocks and into “value” stocks. If your portfolio had been directed more towards growth, you would be losing money. If your portfolio was balanced with an allocation to bonds, you would be losing money twice.

The same impact was felt in Australia, albeit less pronounced given on our stock market “old world” industries such as mining and banking still far outweigh “new world” industries of the “digital economy”. Not so in the US, where the biggest companies are the big technology companies.

Currently, the situation remains one of latent inflation fear as the global economy recovers, hence the risk of a simultaneous bond sell-off and stock market sell-off.

Realistically, that risk has been lingering ever since the GFC. As to whether we’ll ever return to “normal” is unclear at this point.

How many different types of bonds are there?

While you can count the main types of bonds on one hand, they’re generally grouped into three main categories, based on repayment terms. These include short-term bonds (one to five years; intermediate-term bonds (five to 12 years); and long-term bonds: 12 to 30 years.

As well as measuring how long it will take an investor to be repaid, the duration of the bond also determines the bond’s price and how price-sensitive the bond is to changing interest rates.

While bonds can come any number of issuers, here are the main categories of bonds operating in Australia:

Government bonds: Are issued by the Treasury on behalf of a government, and as such are also referred to as sovereign debt. Typically governments issue bonds to finance new projects or government infrastructure. For example, Australian Government Bonds (AGBs) are the safest type of bonds, and if you buy and hold them to maturity, you're guaranteed a rate of return.

There are two main types of Australian Government Bonds (AGBs) that are listed on the ASX:

Treasury Bonds: These are medium to long-term debt securities that carry an annual rate of interest fixed over the life of the security. Interest is paid every six months at a fixed rate, which is a percentage of the original face value of $100. The bonds are repayable at face value on maturity.

Treasury Indexed Bonds: These are medium to long-term bonds. The capital value of the bonds is adjusted for movements in the Consumer Price Index (CPI), which measures inflation.

Interest is paid quarterly, at a fixed rate, on the adjusted face value. At maturity, investors receive the capital value of the bond – the value adjusted for movement in the CPI – over the life of the bond.

Corporate bonds share many characteristics with other types of bonds, but are issued by companies looking for a source of funding to help grow their business. While Australians could up until fairly recently only access corporate bonds through a managed fund or Exchange Traded Fund (ETF) that is no longer the case.

Recent innovations have extended the accessibility of corporate bonds beyond the traditional domain of institutional or ‘sophisticated’ high-net wealth investors. This means self-managed super funds and individual investors can now buy bonds directly from the issuer through a public offer (known as the primary market) at face value, or on the ASX after they have been issued in the primary market.

While investors are attracted to corporate bonds due to their higher yields, the rule of thumb is the higher the yield, the greater the risk.

Given that corporate bonds are issued against the underlying security, the single biggest risk is the company going bust, in which case you could lose your capital and forfeit receiving any coupon payments. Unlike government bonds, there is no government guarantee to pay you back if a company you own bonds in goes bust.

Different types of corporate bonds

Corporate bonds come in all different shapes and sizes, and as such have different terms of structure and risk. Here are the key ones you might encounter:

Senior bonds: Offer investors the first claim to a company’s assets should it go out of business, ahead of other lenders and shareholders.

Senior secured: Are secured against the issuing company’s property, so if the company goes into administration, you’re higher up the queue than other lenders when it comes to being repaid.

Senior unsecured: While these corporate bonds aren’t secured against the issuing company’s property, you’re still ranked ahead of other unsecured bondholders in the queue to be repaid.

Subordinated: Are the last of all bondholders to have a claim on the issuing company’s assets if it goes out of business. However, they are still ahead of shareholders and other creditors, such as vendors that serve the company. 

Investment grade bonds: Are bonds that have been given a credit rating by rating agencies like Standard & Poor’s (S&P), Moody’s and Fitch. They give investors an idea of how risky the bonds are, plus the issuer’s capacity to maintain payments and avoid default.

The best possible rating is AAA from S&P and Fitch and Aaa from Moody’s, indicating that the issuer is extremely likely to meet its financial commitments.

Any rating of BBB- or higher from S&P or Baa3 from Moody’s represents an ‘investment grade’ bond, and suggests the issuer is in a relatively strong financial position.

High-yield bonds: Also referred to as ‘junk’ bonds, they have a lower rating than investment grade bonds, indicating a higher risk of the issuer defaulting on payments. Junk bonds have a rating of or below BB from S&P and Fitch and Ba from Moody’s, and pay a higher rate of interest to reward investors for the higher level of risk.

Zero coupon bonds: Often called dingo bonds in Australia, the issuer has no obligation to make any interest payments during the term of the bond. Only at maturity must the issuer repay the face value of the bond.

Given that investors aren't willing to pay the same amount for a zero coupon bond that they would for a bond that pays interest, zero coupon bonds are sold at a discount to their face value. 

Municipal bonds: Are issued by states, territories or local governments for the same purpose as government bonds, and some of municipal bonds may be tax exempt.

Hybrids

The difficulty for investors considering fixed income allocation is that very few, if any, corporate bonds being issued these days are actually simple, standard debt instruments. Most, if not all, are “hybrid” bonds, which are a combination of debt and equity.

Convertible bonds: Begin life as a vanilla bond, paying a fixed coupon and a return of investment at face value. However, they also contain an inbuilt call option, such that if the share price of the underlying equity exceeds a predetermined level, holders have the option to convert their bonds into equity at that price.

We might view this as “the best of both worlds”, because if the share price is not performing well, the investor will continue to receive coupon payments and will (assuming the company does not go bankrupt) be paid back on maturity. If the share price rallies, an investor may wish the shares had been bought instead, but with convertibles they can decide to jump over to equity.

But again, life is not quite so simple. These days even vanilla convertibles are few and far between. There is so large a range of hybrid forms that it is almost a case of one being unique from any other.

Hybrids could be convertible (investor has the choice to convert), converting (conversion at a price is automatic), redeemable (investor can redeem based on some predetermined factor), redeeming (company can redeem on its discretion), and the list goes on. For some that pre-set share price that triggers conversion may be a moving target rather than a fixed price.

And for others, the complexities are such that only an expert can truly pull them apart and decide what the right price should be, bearing in mind that the greater the complexity, and/or the greater control the company has over the instrument rather than the investor, the higher the price (coupon) will have to be.

Preference shares: Have been around for a very long time and are thus the earliest form of hybrid instrument.

An ordinary share pays a dividend only at the discretion of the company in each dividend period. A preference share, or “pref”, pays a fixed dividend from the time of issue, more akin to the coupon on a bond. Pref prices will move in step with ordinary share prices, hence the hybrid nature of debt/equity mix.

Dividends on prefs must be paid in full before a company can consider paying dividends to ordinary shareholders, and rank higher than ordinary shares in the case of wind-up.

That seems simple enough, until you consider that like bonds, prefs can also be convertible, and converting, and all the other variations on a theme.

The bottom line here is: if you are considering an investment in fixed income or hybrid debt/equity instruments, it is essential you act through a broker who can warn you of any traps and have an informed opinion on whether that particular instrument offers value or not, and whether it suits your own preferred risk/reward profile.

This is the third article in FNArena's series on bond investment. Prevoius articles:

Why All This Fuss Over Bond Yields? (https://www.fnarena.com/index.php/2021/03/31/why-all-this-fuss-over-bond-yields/)

Bonds: Everything You Always Wanted To Ask (https://www.fnarena.com/index.php/2021/05/05/bonds-everything-you-always-wanted-to-ask/)

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

FNArena is proud about its track record and past achievements: Ten Years On

Share on FacebookTweet about this on TwitterShare on LinkedIn

Click to view our Glossary of Financial Terms