Only a bond is a bond
Imagine your adviser telling you not to buy the shares you own on the ASX. That you should instead invest in shares via a managed fund or exchange traded fund (ETF).
You lose transparency and cop a layer of fees. But if you believed the manager could improve performance with active management you may accept the advice – because there is no certainty in the performance of shares over time.
If you were investing only in blue-chip stocks to benefit from the dividends, you would question: why not just go direct?
As the Australian corporate bond market matures, we are seeing more companies using it to source funding and more investors going direct and buying corporate bonds, accessing the same bonds from the same market that the bond funds do.
This means that self-managed super funds and individual investors can now cut out the middle man and benefit, as the large funds and institutional investors do, from including this defensive asset class in their portfolio.
This is significant because only through direct ownership of bonds do you benefit from two key protections: a maturity date and known interest payments.
Two key reasons for investing in corporate bonds direct
They have a maturity date
Most bonds have a face value of $100. Once they are issued the bond price fluctuates, but at maturity investors can expect to get back the $100 face value. This preserves your capital because you know the exact the amount you will receive and the date you will receive it.
Interest payments are a legal obligation and cannot be missed
Interest payments on bonds (known as coupon payments) are a legal obligation of the company issuing them and are non-discretionary. They are paid semi-annually or quarterly, at either a fixed rate, floating rate or margin over inflation. This is unlike shares, where dividends are discretionary and can be cut or not paid at all.
Investing in corporate bonds direct gives you certainty and control. These two features provide reliable income, preserve capital and generate income through economic cycles and give your portfolio the best chance of sailing through in times of volatility.
Indirect investment means you lose key benefits
Choosing an ETF or managed fund for your fixed-income allocation means you miss out on the certainty of a maturity date and interest is paid at the discretion of the manager.
If you invest through a managed fund you no longer have a maturity date on your investment. You purchase units in a pool of assets, providing a much less certain outcome. You have to sell to access your capital and are thus subject to market pricing.
You no longer receive coupon payments, which are instead paid into the fund. While some funds may make a regular distribution, in most instances you can only access income via a redemption request.
Diversification is a risk-minimisation tool to lower the risk of loss through spreading your investment across a broader range of exposures, ensuring all your eggs are not in one basket.
However, as you move up the capital structure from equity to debt and access the additional protections given to bond holders, the need to utilise diversification is significantly lessened. In fact, diversification in the fixed-income world can dilute the value of your investment.
While many fund managers use the same messaging to sell both equity and fixed-income funds, they are quite different. Recent times have seen some bond funds freeze redemptions, thereby eliminating the possibility of liquidity for your investment. I would rather have the support of the global bond market for liquidity than rely on a fund manager’s discretion. With a managed fund there may be a wider range of underlying investments but there is only one exit door and it can shut quickly.
If you use the ASX for your defensive allocation with products such as exchange traded bonds (XTBs), ETFs or hybrid securities (equities) you are subject to the liquidity constraints of the domestic market.
For ETFs, while the underlying investments may be bonds, if you are seeking to sell or liquidate your investment you do not have the massive global bond market’s support – you rely on an investor into that same ETF for liquidity.
Investors who own bonds outright look to the global bond market for liquidity in times of stress and benefit from the “flight to quality”, which increases demand for investment-grade bonds in these times.
High returns are possible by adding credit or duration risk
Bonds come in all shapes and sizes and some can have very high yields of 10% a year or more. They usually offer these returns to compensate for two key risks: credit and duration.
Credit risk refers to the company’s ability to pay interest and return capital at maturity. Companies that are low risk pay low returns, and as the risk increases so too does the yield. One indicator of perceived credit risk is the credit rating given to the company and individual bond issues.
Alternatively, by investing for longer and increasing duration, you can achieve a higher rate of return. Investors can benefit from a positive yield curve where there is an expectation by the market that interest rates are going to increase over time. The current yield curve is only slightly positive, with the difference between a 10-year and 30-year Australian government bond just 1% – investors aren’t being paid much of a premium for investing for longer at the moment
Also, the longer the term to maturity, the greater the uncertainty, which should increase the return available.
Bonds with higher duration, such as long-dated US and Australian government bonds, carry greater interest rate risk and thus have greater price volatility. Where you don’t have the protection of a maturity date it’s important to know the underlying investment profile, including exposure to government bonds, of your managed fund or ETF.
Most bonds are rated independently by one or more of three global ratings agencies. The credit rating determines whether a bond is investment grade or not. When you buy a bond the returns are known in advance. This is isn’t the case for ETFs and managed funds.
Given the greater certainty of your return when you buy a bond direct, I question the value of additional advice, particularly in a very low interest rate environment, when advisers and investors can do it themselves.
In the bond world if a company does not pay its obligations (coupons and maturity payments) it is in default and goes into liquidation or wind-up.
If you are prepared to invest in the equity of a company then surely you would be comfortable holding the debt of that company, knowing that in the event of a default you stand ahead of all equity holders.
Only a bond is a bond. While other investments may provide “bond-like” income they will not provide the two very important protections that bonds do: a maturity date and known coupon payments. While hybrids are considered fixed-income securities and provide a regular interest payment, that payment can be forgone or reduced, not giving investors the protection they expect.
I would ask you to read the multi-page issuing documents. You will see that they pay a dividend, not a coupon, and they do not have a maturity date – in many cases they are a perpetual investment. Sound familiar?
Increase your knowledge
The bond market is still in its infancy in Australia. Many professionals are contributing to the education of advisers and investors, improving direct access to the market through technology and vastly improving visibility and transparency with online reporting and real-time pricing and performance.
With a bond individually managed account you can also incorporate active management of your bonds while maintaining all the benefits of direct ownership. This is a great option for investors who don’t want to spend the time managing their own bonds or have more important things to do, such as enjoying retirement.
We are seeing huge growth in the number of Australian corporates issuing bonds direct to Australian investors, in addition to offshore companies identifying Australia as a growing market for bonds.
So don’t limit your options by relying on the ASX or removing the two key benefits of bonds by investing in ETFs and managed funds. Reintroduce yourself to a traditional asset class, go direct to the global market and benefit from greater choice, certainty and control.