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:
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.
IMPORTANT LEGAL INFO This article is of a general nature and FYI only, because it doesn’t take into account your financial or legal situation, objectives or needs. That means it’s not financial product or legal advice and shouldn’t be relied upon as if it is. Before making a financial or legal decision, you should work out if the info is appropriate for your situation and get independent, licensed financial services or legal advice.