Australian bonds: your secret weapon for a resilient portfolio? (Part I)

Recent recessionary fears have made bonds a topic worth discussing for any investor planning to retain the wealth they’ve built over years of hard work. Or perhaps the recent headlines have given you pause to reflect on the protection you have (or do not have) in place for your portfolio.

Saxo’s aim for this series is for investors to:

• Discover the potential of Australian bond markets.
• Unlock the power of diversification and wealth protection.
• Implement effective strategies for your portfolio.

If you have a large chunk of your portfolio in stocks, this article will give you the information and tools you need to mitigate market risks through a fixed interest allocation in your portfolio, with an Aussie slant.

The series is broken into three parts:

Part I:

• The importance of portfolio diversification – why should you care?
• Fundamentals of the Australian bond markets – how do they work?

Part II:

• How to use bonds to withstand market turbulence
• Reducing portfolio risk and increasing cashflow through bonds - are they an alternative to real estate investments?

Part III:

• Implementing your fixed income strategy
• Different vehicles through which to invest in bonds (ETFs, exchange-traded, OTC, bond funds)
• How you can start today with Saxo’s market-leading offering.

Not diversified? You’re taking on extra risk

Smart diversification involves designing your investment portfolio to withstand market turbulence and provide consistent returns by investing into more than one asset class. If you predominantly own Australian stocks and the ASX goes down, or US stocks and the S&P500 goes down, you could be heavily exposed to losses.

The key is to spread your investments:

• Across different industry sectors, e.g., banking stocks such as CBA or Macquarie, and mining stocks such as BHP or Fortescue.
• Across different geographical markets, e.g., Australia, US, Europe, Japan.
• Across different asset classes that will not react in the same way to changing market environments, e.g., a multi-asset portfolio holding stocks/ETFs, bonds, and real estate.

In the recent market scare, stock markets around the world and across different industries were all faced with sharp declines. Bonds and fixed interest markets were relatively less exposed to the same market risks.

This gives us context into why diversifying across multiple asset classes, rather than just one asset class, is inherently less risky.

Diversifying into bonds - it's a bit like insurance!

If you are travelling with your family and your child is injured, how would you feel in the ambulance on the way to the hospital knowing you had opted-out of purchasing travel insurance?

Just like travel insurance, bonds can offer protection and a degree of certainty for the future by reducing the financial risk you take on in your investments, providing predictable returns and income payments despite the performance of the markets.

Here’s some quick ‘bond jargon’ to help you understand how bonds work:

• Face value: The initial investment amount, repaid to the bond investor at maturity.
• Maturity: The date at which the “face value” is agreed to be repaid at the end of the agreement. E.g., a 30-year bond purchased in 2024 would have a pre-agreed maturity set in 2054.
• Coupon rate: A recurring, pre-determined income payment (cash flow) to the investor for the life of the bond until maturity, predetermined when entering into the agreement.
• Bond price vs. bond yields: Bond yields are oppositely correlated to bond prices (see below).

Source: Reserve Bank of Australia 

So, how do bonds work?

At its core, when a company or a government needs to raise capital, they can issue a bond - which is essentially asking for a loan from investors like you and me.

This is why a bond is sometimes referred to as a “debt asset” and works similarly to a mortgage agreement between a bank and a homeowner. The bond issuer is technically “indebted” to you as the bondholder.

A bond can also be a “fixed-income asset”, meaning the bond provides an income payment to the investor on a recurring basis – typically twice per year.

If we compare real estate investing to bonds (both being recurring income investments with a consistent and anticipated payment), we can say bonds have far lower financial costs and barriers to entry.

The coupon payment is based on the “bond yield” and is just like the interest we would pay on a fixed-rate mortgage for a home purchase. The only difference is that, instead of paying the interest to the bank, bondholders are on the receiving end of this interest payment, and will receive the lump sum of their initial payment at the end.

Government vs non-government bonds

Government bonds: A government, e.g., a federal or state government, can seek to raise capital by issuing bonds.

• Typically a low-risk, low-yield investment.
• Low chance that governments will be unable to fulfil their bond obligations.

Non-government bonds: Non-government entities, e.g., companies, can seek to raise capital by issuing bonds.

• Typically higher risk and higher yield than government bonds.
• The bond-issuing entity could go out of business.

What types of non-government bonds are available in the Australian market?

• Australian financial institution bonds, also known as “bank bonds”:
  • Financial institutions, typically Aussie banks (CBA/NAB/WBC/ANZ/MQG), wishing to raise capital.
  • Bank bonds account for about 50% of the entire non-government bond market.

• Australian corporate bonds (non-banks):
  • Australian companies wishing to raise capital.
  • Have at times paid higher coupons than stock dividends. This makes corporate bonds a potentially attractive proposition for investors that own stocks and wish to spread their exposure while still earning income.

• Asset-backed securities (ABS) issued by Australian-based institutions:
  • Bonds that are pegged to the loan value of a tangible asset, like real-estate mortgages or auto and equipment asset loans.
  • The RBA have stated that “available data suggests that the investor base remains spread across foreign investors, banks and, to a lesser extent, super funds and other similar long-term investors.”
  • ABS can be offered as a “basket” of loans that contain a diverse range of tangible asset loans, e.g., mining machinery, real estate and technology loans.
  • ABS can reduce the credit risk associated with one of the loans in the “basket” defaulting (through intra-asset diversification), and the market risk of one industry facing a downturn.

• “Kangaroo Bonds” - Australian Dollar (AUD) bonds issued by non-residents:
  • A type of foreign bond issued in the Australian market by non-Australian firms, and denoted in AUD.
  • Kangaroo Bonds can be issued by overseas governments, financial institutions, or corporations.
  • These bonds are subject to securities regulation in Australia, which provides investors with a degree of safety and familiarity.
  • Companies may choose to issue Kangaroo Bonds to gain exposure to Australia’s interest rate, or if they need to raise capital in AUD.
  • Companies can also issue Kangaroo Bonds if they wish to expand their investor base by raising funds from Australian investors.
  • A benefit of Kangaroo Bonds for Aussie investors is that the investors are not exposed to the currency risk of purchasing bonds denoted in other foreign currencies. E.g., if an investor purchases Microsoft corporate bonds from the US and the bond’s price moves favourably but the USD advances against the AUD, the investor may not benefit due to the currency movement.

Australian government bonds (AGBs) are classified as follows:

• Australian Commonwealth government bonds (ACGBs):
  • Issued by the Australian federal government.

• Semi-government bonds (“semis”):
  • Issued by Australian states and territories e.g., NSW, Victoria.
  • Almost 90% of semis are fixed-rate bonds (locked-in yield).

What are the advantages of fixed income investing, and what are the risks?

Investing in bonds offers several benefits:

• Excluding the risk of default, bonds offer a “guarantee” of the return of the original investment at maturity.
• Regular and reliable income on your investment.
• Peace of mind in not worrying about the fluctuations of the stock market.
• Flexibility to sell the bond before maturity.
• The option to purchase inflation-linked bonds to account for rising costs.
• The option to elect either a fixed- or variable-rate bond.

But here’s the kicker:

• The “guarantee” of coupon payments and face value repayment at maturity is not truly guaranteed. This is called “credit risk” - the risk of the entity defaulting on their debt to the bondholder. This risk is usually factored into the yield, i.e., a higher credit risk means a higher bond yield.
• Another risk is the “opportunity cost” in not being more heavily invested into higher-yielding, higher-risk asset classes such as stocks.
• While the face value of the bond is “guaranteed”, no further capital gain or growth is returned at maturity.

This means investors must manage their risks by doing their own research on the bond-issuing entity, including their history of repayments, credit rating, and financials.

Staying on top of general stock market performance can also be advantageous when determining how much opportunity you are willing to forego in order to gain greater certainty.

Summary

You should now be able to explain to your friends, family members and/or cats about the broad function of bonds, the ins and outs of the Australian bond markets, and the strengths and weaknesses of each bond type.

You should also understand the power of diversification across asset classes, and how bonds can offer intelligent diversification that provides safety against stock market corrections.

In the next article, we will explore how Aussie bonds can protect your equity portfolio during tough times.