Safety first: David Thornton on the role of bonds
Investors who want to avoid sharemarket volatility and possible loss of income have a more predictable alternative
High-quality bonds are arguably the leading defensive asset for retail investors, lauded for their capital preservation qualities. But what exactly are they, how do you buy them and what role do they play in a portfolio? Bond machinations can be complicated. In one sense they’re quite simple, but dig a little deeper and you’ll find a pretty big rabbit hole to fall down.
Bonds are essentially loan contracts issued by either governments or companies. You lend them money and in exchange you receive a coupon payment (yield), usually once or twice a year. At the end of the agreed term, the initial loan amount (face value) of the bond will be repaid to the bond holder – provided the issuer is solvent.
Australian government bonds are AAA-rated – the top credit rating – so creditors will almost certainly be paid.
On the other hand, lower quality corporate bonds provide income yield comparable to dividends. But unlike issuers of dividends, issuers of bonds are legally obliged to pay the coupons. For these reasons bonds have carved out a well-earned place as fixed-income stalwarts.
But here’s where it gets complicated. Investors can hold bonds until they mature, or sell them before then on the secondary market.
“The valuation of bonds in the secondary market is simply about the return that’s required to offset the risk of not being repaid,” says Jonathan Sheridan, from FIIG Securities.
How risk is calculated
Risk depends on two factors. The first is the creditworthiness of the issuer or, put another way, the credit risk for holding the bond. Bonds issued by governments or large companies are considered a safe asset, second only to cash.
“Bonds issued by many governments are highly rated, so they perform well in risk-off environments,” says Manusha Samaraweera, from PIMCO. “We call them a flight-to-quality asset. When a downturn in economic sentiment occurs, investors flock to these assets.”
There’s also a strange regulatory quirk worth mentioning: retail investors are prohibited from knowing the credit ratings of the bonds they buy, hold and sell.
“Credit ratings have been determined to be wholesale products. Ratings agencies only have wholesale licences and therefore retail investors can’t be shown credit ratings,” says Sheridan. “That is nonsense because a credit rating is a key part of calculating risk.”
That’s analogous to a car buyer not being privy to its safety rating and having to settle for the dealer’s assurance that it’s safe – or not.
Corporate bonds carry greater risk but also pay higher yields.
The second factor that influences a bond’s risk is maturity: the length of the loan contract. “The longer a corporate bond’s maturity, the more chance it could default,” says Samaraweera. “That’s why corporate bonds usually have shorter maturities.”
The longer a bond’s time to maturity, the greater the yield investors can expect to be paid because there’s a higher level of uncertainty.
This is where you factor in duration, which is a measure of a bond’s interest rate risk. The duration measurement takes into account the bond’s maturity, yield and the coupon payments left to be paid out.
Bonds are therefore more or less affected by the interest rate environment depending on their duration.
Impact of interest rates
If interest rates go up, the bond will trade at a discount because newly issued bonds will pay investors higher coupon rates than old ones. The longer the duration, the more sensitive the bond will be to changes in interest rates.
Because the terms of a bond don’t change through its lifecycle – that is, it will continue to pay the same coupon rate at the same intervals – the yield will change as a percentage of the amount paid for the bond. In other words, if an investor pays more for a bond then they will receive a lower yield as a percentage of their total investment. The opposite also applies.
So, if you hear on the finance news that bond yields are falling, that is because investors are paying higher prices to hold the bonds. So yields fall in risk-off markets characterised by high volatility and rise in riskon markets with low volatility. It’s for this reason that bond yields are used as a finger-in-the-wind measure of fear or confidence in the markets.
But there’s a caveat. This is normally how it works but due to the pandemic, all bets are off.
The Reserve Bank is artificially controlling prices, and by extension the yields, by buying up bonds by the truckload to maintain liquidity in the market during these troubling times, in a program known as quantitative easing. This has broken the negative correlation high-quality bonds have typically had with equities.
“Over the past 10 to 15 years, you’ve seen a negative correlation between bonds and equities,” says Justin Tyler, from Daintree Capital. “That’s been useful as bonds have provided a shock absorber to equities.”
So, when economic conditions soured, there was room for bond yields to fall and prices to rise.
“That’s not the case now,” says Tyler. “We think that going forward, the correlation between high-grade bonds and equities will be low.”
Where they fit in a portfolio
Bonds are generally underutilised by Aussie investors, who have generally turned to term deposits to warehouse their cash.
“Historically, term deposit yields have been high, so sitting in cash hasn’t been detrimental to your portfolio,” says Sheridan. “And in the same way people don’t move their mortgage, they don’t move the money in their term deposits.”
Sheridan also points to the perceived wisdom that’s pervaded the wealth management industry for years: that you need to hold three year’s income in cash.
“That’s why 20% of self-managed super funds are in cash – because they’re being advised to do that. If peo
ple had 40%-50% of their portfolio in investment-grade bonds, they wouldn’t need a cash buffer because they wouldn’t have to worry about dividends being cut from their equity allocations.”
So how should investors make better use of bonds? “They have to be clear about the role they want bonds to play in their portfolio,” says Tyler.
Broadly they have two purposes: a defence against a sell-off in riskier assets and for income generation. The two roles are chalk and cheese, as are the bonds that service each objective.
High-quality government bonds are a mainstream hedge against market volatility, much like gold. Highgrade bonds and gold share the same space on the defensive-to-growth spectrum.
But they do differ depending on market conditions. “Gold is very good when people are worried about a deflationary environment,” says Tyler. “Government bonds have historically been good performers against this backdrop, but the issue is interest rates on bonds are at lows we haven’t seen for literally thousands of years.
“If you want income then you can take more risk via corporate bonds, but in doing so you’re reducing the amount of defensiveness you have against equities.”
The further you go down the credit spectrum, the more the potential to overlap between bonds and equities. In other words, the lower the quality of the bond, the more their yield and risk profiles tend to converge with equities.
Still, Tyler says it’s difficult to draw a distinction between low-quality, high-yield bonds and equities because they’re designed so differently. One is part ownership of a company and the other is essentially a loan contract.
The second purpose, generating yield, is served by higher risk corporate bonds.
“During a downturn, corporates may find it harder to pay off their obligations, and therefore the prices will fall in deteriorating economic environments,” says PIMCO’s Samaraweera.
High-quality bonds are a good way to manage risk in your portfolio, and you can add to this through diversification of bonds.
“We advocate diversification across different issuers and diversification through tenor [time to maturity],” says Sheridan.
That way you get exposure to a range of sectors and a range of maturities that carry different levels of risk.
Sheridan recommends moving up the quality spectrum when it comes to bonds with longer maturities. “If you don’t get the face value of the bond back, your return won’t make up for that.”