They say slow and steady wins the race, but with bonds, this may not always be the case. With record low interest rates and a bubbling equities market, should bonds have a place in your portfolio? Or are you better off broadening your horizons to other investments to maximise long-term wealth building?
In this blog, we lay out why investing in bonds might not be the best move in your 20s, 30s, 40s or even 50s. And what your options are to achieve the same stabilising, smoothing effect bonds have traditionally offered.
What’s a bond?
Bonds are a type of fixed income investment. You might have heard the terms corporate bonds, government bonds and floating rate notes. These investments are where you ultimately lend money to a company or government. As the lender you’re called a bondholder.
If the company or government you’re lending to is likely to default, the interest rate offered when the bonds are issued (known as the “coupon”) will be higher – insurance for that risk. An assessment by a credit agency helps the investor attempt to quantify that risk.
If you’re an everyday Kiwi investor, you’d mostly be investing in a bond through a fund. To buy a bond directly you’d need many hundreds of thousands and be a wholesale investor (i.e. have access to do so). People like bond funds because by investing in these you get a piece of a whole range of bonds issued. This is as opposed to lending all your money to one company or government (the issuer).
If a company goes bankrupt or even just strikes hard times, bondholders are more likely to get some money back as they rank ahead of shareholders. This is, however, not a guarantee, as they rank behind employees, the tax department, suppliers and bank lenders. Many bondholders found that out in 2007.
Why invest in bonds?
Stability
Bonds are considered more stable due to the way they are priced and traded in comparison to equities. The nature of trading in the bond markets is so vastly different to that of the share markets; with bonds being traded much slower at smaller quantities and equities much faster at larger quantities. As a result, bond prices are more stable.
Infratil currently has 12 bonds available on the bond market, however in comparison they have over 722 million shares on issue and available to trade. If, as a bondholder, you wanted to sell your bond, the process to do so can take matter of days. You also don’t have a real-time indication of price and the number of available buyers is smaller. If you’re selling in a share in Infratil, however, you can log into a broking platform, enter your units and press sell. Voila – you’re done in 30 seconds.
With bonds, you don’t get the same level of volatility in your portfolio as you would from the equities portion of your portfolio, reiterating their stabilising nature.
Guaranteed* capital
In the hierarchy of investors involved in a company, those who have lent money to the company (bondholders) rank higher than those who have simply bought shares in the company. While this does have the benefit of providing a guaranteed income for a fixed period of time, a downside is that any inflation has the potential to eat away at those returns, with the value of the underlying capital decreasing over time.
In the current low interest rate environment, this is the largest risk because the effective interest rate after inflation is 0%, if not negative. Therefore, investing too heavily in fixed interest can mean you’re effectively going backwards.
*while coupons from bonds can’t be 100% guaranteed, their contractual nature means there is a high chance you’re near guaranteed capital.
Downturn protection
Typically in a recession central banks around the world will use interest rate reductions to stimulate growth. When interest rates fall, the value of bonds rise. If you, as an investor, have bonds as well as shares in your portfolio they can counterbalance each other during times like these. This may have stood true for the past 40 years, but what happens when the wholesale interest rates are already at 0%?
When’s the right time to invest in bonds?
For the reasons above, bonds in an investment portfolio aren’t generally viewed as return enhancers but rather seen as volatility dampeners. If your time horizon is short, as in you are truly going to spend that money soon at a fixed point in time, then it makes sense to use bonds. Otherwise, it’s a speed limiter on your wealth.
The reality is, if you’re investing for a long-term goal (10+ years) you shouldn’t be too concerned about market volatility because you’ve got the time to ride it out. This is why, when we hear from people in their 30s saving for their retirement (a 30+ year time period), having an exposure to bonds it just doesn’t make logical sense. Especially when the risks highlighted above mean you could be greatly restricting your future returns, during a time when you cannot even access the money. If, however, you were less than five years away from your retirement, bonds may be an asset you’d seriously consider investing in.
If not bonds, then what?
Now, you might be wondering, if bonds aren’t for me then what should I do with that extra portion of my portfolio? There is a range of index funds out there, which in combination with one another can achieve a similar smoothing effect that you may have seen through investing in bonds.
A couple of great examples of these are Kernel’s Global Infrastructure Fund and Global Dividend Aristocrats Fund.
Infrastructure funds have similar attributes as bonds, in that they’re designed to dampen volatility while providing diversification. Infrastructure, the classic backbone of modern societies, typically benefits from guaranteed government contracts as well as limited competition. They can also be slightly higher-yielding as most infrastructure contracts are inflation-linked so can provide passive income, while still being exposed to the potential of capital growth over time.
In addition, our Global Dividend Aristocrat Fund is designed to be a substitute for the income-generating portion of your portfolio. As a high yielding fund, it may work well for those that require income from their investments, whilst also benefiting from global growth. The Dividend Aristocrats in this fund come from a range of sectors, which when coupled with a strong historical dividend history, gives confidence in the stability of future pay-outs (distributions), much like bonds.
