Bonds or shares…? Diversity is best

Bonds have attracted more than their fair share of attention lately – courtesy of sovereign debt issues in Europe and the efforts of governments globally to reinvigorate stalled economies. But while bonds may be making headlines for their role in policy, they also offer valuable opportunities for investors.

Bonds fall into the ‘fixed interest’ category of investments, which includes term deposits, mortgages, securities, corporate bonds and government bonds. It’s an asset class that is synonymous with regular, stable returns. What’s less well known is that bonds offer opportunities for capital gains, and along with the diversity they provide, this makes bonds an important addition to any portfolio.

Bond basics

Unlike shares, which involve owning a stake in a listed company, bonds are essentially a loan from the investor (or ‘bondholder’) to the bond issuer – typically governments, semi-government bodies and large corporations.

Australia has a relatively low level of public debt so corporate bonds make up a reasonable proportion of the local bond market. Government bonds are often considered the safest type of bond, however both government and corporate bonds generally come with a credit rating issued by agencies like Moody’s or Standard & Poor’s, which provide a guide to the degree of risk associated with each bond.

Like most loans, bonds have a payback day, known as the ‘maturity’ date. This is when the bond issuer will pay out the ‘face value’ of the bond – in effect the purchase price of the bond when it was first issued. However, before a bondholder receives their payout at maturity date, they also receive ongoing payments at specified intervals, called ‘coupon’ payments, during the life of the bond. These coupons are an interest return based on a rate that can be fixed or floating (changing in line with bank bill rates, the official cash rate or some other benchmark). Following is an illustration, and for the sake of simplicity we’ll focus on fixed interest rate bonds.

Let’s say you purchase a new Australian Treasury bond with a face value of $10,000, a coupon rate of 5% per annum and a maturity date of 2022. What this all means is that you are lending $10,000 to the Commonwealth Government for a 10-year term. Each year you will receive interest income of $500 (being 5% of $10,000), then, in 2022, the government will return the $10,000 face value, or principal, to you.

Defence against uncertain times

For the issuer, bonds offer a source of new capital. For investment managers, bonds hold several points of appeal. Firstly, they are a reliable and predictable source of interest income for investors.

Secondly, bonds tend to provide protection against a downturn in the economy. As an economy slows, central banks often reduce interest rates in an attempt to stimulate spending and production. Falls in market interest rates can push up a bond’s market value, which is why negative economic news can stimulate the bond market.

Together, these factors explain why bonds are regarded as a ‘defensive’ asset – one that offers shelter from economic storms. Shares on the other hand are ‘growth’ assets, which traditionally rise in value over time even though they can experience short term dips.

There is another reason why bonds are worthwhile considering for investment strategies, and this relates to the counterbalancing effect they have on equities.

Historically, bond yields have tended to move in an opposite direction to returns on equities – when bond yields decrease, their prices go up, which means that expectations for growth are probably falling, but when bond prices rally, it is usually a soft equity market. This tendency to move in opposite directions is technically termed ‘negative correlation’.

Shares and equities – a compelling blend

It is this negative correlation between bonds and shares that makes the two assets such a compelling combination for most investors with a long term horizon. In today’s climate of subdued economic growth, bonds act as a buffer against weak sharemarkets.

As BT Investment Management’s Head of Income & Fixed Interest, Vimal Gor, puts it, “as a defensive asset class, fixed income should protect investors when they need it most, in times of equity market stress”.

The ‘yin and yang’ of equities and bonds

It is worth stressing the importance of considering both shares and bonds. It’s a strategy that offers investors the best of both worlds – the potential for strong capital growth and tax-friendly dividends from equities, and safe, regular income from bonds.

The following BT Investment Management (BTIM) research sheds a revealing light on the benefits of diversifying into both bonds and shares, where bonds can help enhance returns during ‘down’ market periods.

In extremely bullish markets where equity market returns exceed 15%, a balanced Australian portfolio combining shares and bonds, since 1992 has averaged an annual return of around 16%, compared to a 25% annual return in an all-shares portfolio¹.

So, this seems like a good argument for holding an all-equities portfolio. The trouble is, it only holds true during the good times. Chart 1 below shows that in ‘down’ markets, where equity values drop by more than 15% p.a., since 1992, the Australian equities-only portfolio fell by a much greater amount, almost 30% p.a. However, a portfolio comprising both bonds and shares experienced a far lesser fall during the down years; of about 8% p.a. Vimal Gor gives this research relevance to today’s uncertain market conditions, saying, “Your fixed interest exposure is like an insurance premium. It generates positive returns when you’re experiencing loss on the equity portion of your portfolio, thereby minimising the total losses.”

Of course, markets don’t continually experience wild swings – either up or down. Over time, fluctuations are smoothed out, and the BTIM research found that in more normal markets (where equity returns range from -15% to 15%), since 1992 an Australian portfolio combining shares and bonds returned around 6% p.a., significantly ahead of the approximately 4% gain on a share-only portfolio (chart 2).

A matter of balance

Investors rattled by volatile sharemarkets may be tempted to swing the pendulum too far in favour of bonds and other fixed interest assets. But diversification is a vital attribute of any portfolio, and Crispin Murray, Head of Equity Strategies at BTIM points out several factors highlighting the merits of including equities in a portfolio.

To begin with, lower interest rates will help to support the economy, as well as our listed companies, many of which have reduced their debt levels in recent years. Crispin says, “Low corporate gearing makes equities less risky.”

Crispin acknowledges, “We have had the worst recovery from a bear market in 90 years but the market has de-rated to levels which provide good support, and lead indicators suggest we are close to the nadir.”

He concludes, “Now is not the time to give up on equities; blending them with bonds provides a good risk/reward balance.”