As an investment, bonds are both underrated and misunderstood. They are often seen by investors as boring, defensive, predictable and producing very little in the way of income. In short, they don’t hold much interest to income-focused investors, especially during a time of record low interest rates and in a rising share market. Furthermore, in the event of rising interest rates, holders of fixed interest securities will see a fall in the value of their invested capital.

What is a bond and how are they traded?

A traditional fixed-coupon bond is a fixed income investment where an investor lends money to an entity (typically a government or company) for a defined period of time at a variable or fixed interest rate. Bonds can be traded. The annual interest paid on a bond is calculated thus: the amount invested multiplied by the days invested divided by 365, multiplied by the interest rate.

Bonds can be an important part of a well-balanced portfolio, particularly during uncertain times when share markets and property markets get the jitters. If shares fall, say, 10 per cent over a month or two, an investment guaranteeing a 1.6 per cent annual return with a guaranteed return of capital all of a sudden looks more attractive.

In a rising share market, bond prices often fall as people sell bonds to move into shares, with bond yields consequently rising. But in recent times, the opposite has been the case, with bond prices rising along with share prices due to unprecedented monetary policy stimulus by various central banks, not least our own Reserve Bank of Australia.

Bond yields are now poised to potentially rise as central banks start to contemplate reining in their monetary largesse and governments pull back on fiscal stimulus as their economies recover. Currently, the Australian government has more than $832 billion of bonds and treasury notes (government debt) on issue, up from just $40 billion at the end of 2007.

Here are three key reasons why bonds should be considered for balanced investment portfolios:

1. Bonds provide a counter-balance to equity risk: Bonds represent a portfolio counterweight. If equities go down, bond prices generally go up (and hence bond yields go down). For those investing in non-government guaranteed bonds, the premium received over and above the government bond yield is a measure of the risk of not getting one’s money back at maturity, as well as a value of the premium to the investor on the term of the investment. Corporate bonds can be riskier than government bonds because companies historically fail more often than governments (not including those in South America). An investor holding Australian government bonds can be very confident of getting the principal returned at maturity.
2. Bonds can be used to position a portfolio for changes in the economy: If there is the potential for a recession on the horizon, having exposure to bonds will benefit a portfolio. This happened in Australia before the most recent federal election. As investors moved into bonds, forcing prices higher, yields fell to a record low level (1.71 per cent for 10-year-bonds, down from 2.95 per cent a year earlier). By contrast, in 1987, before the stock market crash, bond yields were more than 15 per cent. Investors were overweight in equities because returns from equities were so high. Today, however, inflation has fallen and economic growth has slowed. Wages are stagnant and the economic outlook is weak but looking positive. Similar things have been happening in the US, the world’s largest economy.
3. Bonds can be used to take advantage of the economic cycle, via inflation-indexed bonds: Investors concerned about inflation can invest in inflation-indexed bonds, where the rate of inflation on a quarterly basis is added to the coupon rate of the bond. With inflation-indexed bonds, the market value of the bond will always rise in an inflationary environment. A fixed-rate bond has its coupon fixed at issue, with interest paid six-monthly for the life of the bond. A floating-rate bond pays a margin above the floating benchmark (say the 90-day bank bill swap rate). When interest rates and inflation are rising, it’s better to own floating-rate bonds or inflation-indexed bonds.

What it means when yield curves invert:

The longer you lend money to someone, the greater the interest rate you should receive, right? Not always. On May 29, 2019, the yield on 10-year bonds fell to 1.484 per cent, which took it below the cash rate of 1.5 per cent. It was the first time in seven years that this had happened. This simply means that someone who is prepared to lend their money to the government for 10 years would get no greater return on their investment than someone putting cash in the bank overnight, so long as the short-term cash rate remains unchanged. There were essentially two reasons for this: the wholesale market believed the Reserve Bank would shortly cut interest rates (so bond prices rise and yields would fall); and the outlook for inflation and economic activity in Australia was weak, fuelled by the growing threat of a US-China trade war. The theory used to be that an inverse yield curve, as the phenomenon is known, was a harbinger of recession.