Smart Investor: Getting Started, October 2013

Smart Investor, October 2013

We are often told by financial planners and fund managers that we don’t hold enough bonds in our investment portfolio. Bonds and other interest-bearing securities – known collectively in most of the world as fixed income, but more commonly in Australia as fixed interest – help to stabilise a portfolio by providing a steady, predictable, defensive income stream quite different from the day-to-day volatility of shares.

We all have some exposure to this asset class through our super funds. The default option of AustralianSuper, for example, one of the biggest super funds in Australia, has a strategic asset allocation of 13% to fixed interest, and can operate within a range of 0-25%. But that’s still low by global standards. “Broadly, super funds are very equity-biased,” says Steve Lambert, executive general manager, global capital markets at National Australia Bank. “Of the OECD countries, we have among the lowest amount managed in fixed income.”

One reason we don’t hold more is that historically it has been difficult to do so. We can go through mutual funds, but buying directly has been challenging.

Partly for this reason, a programme has been launched to list bonds on the ASX, so you can buy and sell them just like a share. The biggest step in this process has been the recent move to list Australia’s Commonwealth Government Bonds on the exchange;  the ASX’s shorthand for these securities is Exchange-traded Australian Government Bonds.

At this stage there are two types of these exchange-traded bonds: treasury bonds, which are medium to long-term debt securities with a fixed face value, which carry the same annual rate of interest over the life of the bond, paying up ever six months; and treasury indexed bonds, whose value adjusts for changes in the Consumer Price Index, or inflation. These pay interest quarterly at a fixed rate on the adjusted capital value.

On the face of it, there is a lot to be said for these. They are considered the safest securities available in Australia, being backed by the government itself: whereas a company may go under, a government can always print money as a last resort, protecting your investment. You know what return you’re going to get and when you will get it, you gain diversification, and now that they’re listed you don’t risk your money being locked away or difficult to redeem. And the treasury-indexed bonds are a handy hedge against inflation.

On the negative side, look at what they pay. The coupon on listed government bonds can be as high as 6.25%, meaning an interest rate of 6.25% paid twice annually, which sounds pretty good. But, as the costed example in the box shows, that’s not quite the whole picture, because when you buy an exchange-traded bond, the purchase price will include some accrued interest that the bond has already paid, and which you won’t get back when the bond matures. What really matters is something called the yield to maturity: that’s your actual return, assuming you don’t sell the bond before maturity. The box explains this in greater detail, but in any event, the actual yields on the bonds vary from 2.301% to 4.493% – the longer the duration of the bond, the higher the yield – which has not yet struck many investors as attractive considering the fact that they can already get that on their risk-free, government-guaranteed bank deposits.

This may well change because of the recent cuts in interest rates, which are already flowing through to reduced rates of interest in bank accounts. As those rates fall, investors may start taking money out of the bank and looking for other things to do with it; government bonds will be a strong candidate. It is worth understanding, though, that if interest rates start to rise again (unlikely in this environment, but still) then the price of a bond will fall, which can create a capital loss if you sell it before maturity.

For those seeking greater yield, another thing to consider is the next step in this development of the market: listed corporate bonds.

Australian retail investors have a long-standing relationship with listed corporate debt, but historically have done so through complicated instruments known as hybrids, which combine debt and equity characteristics. These have generally paid a high yield, but may in certain circumstances be turned into shares – every hybrid is different, and they are a subject for another article.

Now, there is a simpler way: investment in what you might call more plain vanilla bonds. These work just like government bonds: they have a coupon, defining the rate of interest they pay; they pay it semi-annually; they have a term, and a fixed maturity date; they can be fixed rate or floating rate, and if floating, that is usually linked to a benchmark like the interest rate for three-month bank bills; and they have both a face value and a market value.

The difference is that corporate bonds pay a higher rate, for one good reason: they carry higher risk than government bonds. In buying a corporate bond, you need to be confident that the company in question will be able to pay interest on its debts, including your bond. Incidentally if you buy a corporate bond (or any bond) at launch, there will be a prospectus to look through first, and your investment will be at the bond’s face value. It’s worth looking out an ASIC guide to corporate bonds, distributed on the ASX site, for a guide to reading a prospectus.

The market for straightforward listed corporate debt is in its infancy in Australia, but the ASX has high hopes that the listing of government bonds will be followed by a broad listed corporate bond market with plenty of choice for investors.

One other thing: it’s worth remembering that, ever since the ASX permitted the listed of fixed interest exchange-traded funds, there is another easy option for getting bond exposure. ETFs can also be bought and sold like a share, but they represent a whole index, or perhaps a basket of securities. As of August, there were 11 cash and fixed income ETFs available on the ASX, from broad-based fixed income indices to government bonds and corporate bonds. The main issuers are iShares, Russell, State Street and Vanguard, many of them tracking underlying indices from UBS.

EXAMPLE

The security with the ASX code GSBK17 is for a government bond maturing on February 15 2017, which pays a coupon of 6%, one of the best of all the listed government bonds. This bond’s face value is $100, but on August 20, it was trading at $110.397.

Why the difference? That’s because the purchase price reflects not only the face value, but the accumulated interest the bond has already paid. And if you hold the bond to maturity, what you get at the end is the face value – $100 – plus the final coupon.

Let’s assume you buy 100 of these, for a total of $11,039.70, not including brokerage costs.

So let’s work out what you’re really going to get. The next payment date is February 17 2014, and then there will be others in August 2014, Feb 2015, August 2015, Feb 2016, August 2016 and the final one upon maturity in Feb 2017. There is a 6% annual coupon, so on each of these half-yearly occasions you will get 3% of the face value of the bond. So with your 100 bonds with a face value of $100 each, you would receive $300 interest on each payment date, or $1,800 over the remaining life of the bond. When the bond matures, you will get back $10,000 – the face value. So your return has been the $10,000, plus the $1,800 in interest, minus the $11,039.70 you invested. That’s a return of $760.30 – less than 3% per year. You don’t buy government bonds to get rich quick, but to build money slowly over the long run, and in particular to protect capital you don’t want to risk.