Why invest in bonds? - Eureka Report article
Why invest in bonds?
PORTFOLIO POINT: They form an important part any portfolio, but how do they perform?
The cash and fixed interest parts of any investment portfolio are important: they dampen the volatility from shares and property assets, provide liquidity and are, in themselves, an important source of investment returns.
Traditional investment theory instructs investors to seek out an allocation to “bonds” or loans that investors make to companies and governments in exchange for a series of interest payments and the return of their money at a set maturity date.
But do bonds really deliver investors a significant advantage over cash and term deposits?
This question has a special relevance for Eureka Report readers because you could argue that the strong equity market culture that exists in Australia occurred at the expense of a robust bond market.
The domestic bond market became a niche dominated by institutions and high net worth investors and the minimum investment amount was often prohibitively expensive for the investor who wanted to invest $10,000 or $20,000, for example.
As a result, a number of products have been sold to investors that purportedly had exactly the same qualities as bonds but didn’t. This category includes hybrids, mortgage funds, hedge funds and even listed property trusts.
When the GFC descended we quickly found out what Warren Buffett meant when he said that you only find out who is swimming naked when the tide goes out: many investors found themselves “underweight clothes” with either too little exposure to true defensive investments, or the wrong type of defensive investments.
So let’s compare the returns from bonds against the returns from online cash accounts and simple term deposits to see if we can produce any clarity around the subject for the retail investor.
For this exercise I have assumed that the investor starts with $10,000 and invests for a five year period through to the end of September, 2010. I have ignored tax, although investors in cash and fixed interest investments should factor this in to their decisions.
I have considered four different investment approaches:
1. Invest $10,000 in a 12 month term deposit, reinvesting the income and rolling the investment over at the end of each 12 month period. If you are interested, the RBA provides various statistics on the historical performance of term deposits (click here).
2. Invest $10,000 in a high interest online bank account for the five years, again using RBA data for our modelling.
3. Invest the $10,000 in a bond index fund. Bond usually have a face value of $500,000, so are difficult for most investors to access. By accessing a bond index fund like the UBS Australian Composite Index we can invest smaller amounts and expect to pay less in the way of fees.
4. Invest the $10,000 in a traditionally managed bond fund. The reason fund managers exist is because their skills add value for the investor so it stands to reason that we should add them to our sample. We’ll use the median-performing Australian Bond fund over the five years to the end of September, 2010.
The table below summarises the results:
The results are net of fees and the difference between the top and bottom performers is less than 3% over five years. In particular, note the bond index fund outperformed the median managed by more than 2%.
Research on the subject supports our findings. A paper by Gallagher and Jarnecic, ‘The Performance of Active Australian Bond Funds', published in the Australian Journal of Management, summarised their work as documenting “significant underperformance for retail Australian bond funds after fees”.
The bottom line is that there is not a huge difference in returns between the various strategies, although had you rebalanced your exposure on a regular basis over the five years you may end up with a different picture.
If you take into account that the Australian bond funds can rise and fall in value, the slightly lower return from the term deposit and online account looks attractive.
An area that we have not looked at in this comparison is the increasing number of fixed interest investments listed on the ASX. In this context it was interesting to see Commonwealth Bank launch another $500 million bond issue earlier this week and although some questions were raised as to where bond holders would rank in the unlikely event of a default, I’m sure Elizabeth Moran will enlighten us in her column on Monday.
The “defensive” part of a portfolio plays an important role in providing liquidity and to dampen overall portfolio volatility. The advent of the online cash account, which offers investors access to an attractive cash rate, may make cash somewhat more attractive compared to bonds than they have been in the past. The increasing number of ASX-listed bonds may also help meet your asset allocation requirements in this regard.
All of these investments would seem to have a place in the defensive part of a portfolio – but perhaps the most important decision is to make sure that if you hold high-risk investments such as construction-backed mortgage funds, hedge funds and listed property trusts that you don’t consider them to be defensive assets in the first place.