Investing in Bonds
We talk a lot about the main growth part of our portfolios – stocks and shares.
However, we do not spend much time looking at the ‘defensive’ section of the portfolios. Most of you will be in a 70/30 or 90/10 split in favour of growth v defensive.
So, I thought I would write a little this week on what makes up this piece of the puzzle.
The simplest potential component is plain old cash. With Australia’s previously higher interest rates, this was a nice place to earn a steady return of a couple of percent without too much worry. We now see this squeezed right down to near zero, so where do we head?
Most of the defensive component is now in bonds. But what exactly is a bond?
Bonds are used by large institutions (governments, banks and businesses) to loan and borrow money.
If we start with the premise of a term deposit, that we will be familiar with:
We give money to a bank, for a fixed term of months or years. In return the bank give us interest and return the deposit in full at the end of the term. This is known also as a Bond. While our money is with the bank, they will lend it on again via credit cards and mortgages at a higher rate than they pay us.
In a similar way, larger (non-banking) companies that need money for expansion may also offer bonds to other companies, banks, and investment funds. For example, if Coles wanted $50m to build a new store, they won’t head down to the local Westpac to take out a loan, it’ll be funded by these institutions lending money to them. These are known as Corporate Bonds.
If you are a big enough institution you can also lend money to the Government (via the Central Bank.) You’ll get a lower interest rate than lending to a Corporate (as there’s little chance of default – a central bank can print money to cover its liabilities.)
So how does this make us, as investors, any return?
The defensive section of your portfolio will be invested in bond funds which spread your money over 1,000s of different bonds, each with different issuers and terms – as with shares, diversification is key, as we never truly know what the future will hold.
We hold bonds in a portfolio, as they generally go up in value when the stock market falls.
As you can see in the graph, over the long-term bonds average less than stocks.
So why hold an asset that is likely to return less? There are three good reasons:
1) Stability – when stock markets fall, our defensive component can help us mentally cope and avoid withdrawing from the market by holding or increasing its value.
2) Time – when equities fall, it is a common strategy in retirement, to take regular pension payment from the defensive part of the portfolio, to give us time for the equities to recover.
3) Inflation protection – unlike cash, bonds have generally beaten inflation over time.
Equities are how we own a share of institutions and their future profits. Bonds are how we lend to institutions.
Bonds are an ‘emotional’ asset class. On their own they won’t provide most investors enough return to continually increase their portfolios ahead of inflation and withdrawals. They do help stop us running from equities during downturns, when it is most important to hold onto them.
If you are still some way from accessing your super, there is a good argument not to have any bonds in your portfolio. Some may choose never to hold them if they can mentally handle volatility. Full disclaimer, I don’t currently have them in my savings but I expect to build this in a little later in life.
As ever, if you have any questions, do let me know,
