Australia, Personal Finance - Written by on Sunday, March 15, 2009 13:23 - 0 Comments

Aussie bonds: when boring is good

Australian Financial Review, March 2009

Last year, as your shares went up in smoke and your super evaporated, there was a way you could have been earning almost 15%: boring old Australian bonds. In 2008, as the Australian stock market fell 38.9%, the UBS Composite Bond index – the most widely referred to benchmark for Australian fixed income – went up 14.9%.

That’s quite a return, and most out of character: the same index is up a more pedestrian 6.8% a year over five years, and even that is higher than the sort of figure people normally hope to get out of bonds over the longer term. Bond investments are meant to be the defensive, anchoring bit of a portfolio, an irksome drag on returns in the good years but a vital insulator when things turn bad. “Fixed rate bonds have traditionally been a place of refuge for investors when economic growth deteriorates,” says Greg Michel, head of fixed income at ING Investment Management in Sydney.

It’s the scale of that economic deterioration, with its savage effect on shares, that has made bonds look so good. “Falling interest rates produce capital appreciation in bond investments, and strong outperformance when compared with growth assets such as equities,” says Michel. Around the world central banks, Australia’s included, have slashed cash rates, making cash less attractive than it used to be in Australia, while at the same time bonds have performed strongly.

Before assessing the outlook, though, it’s worth being clear that there are many different kinds of bonds, with very different characteristics and accessibility. At the top of the tree, in terms of the safety of the investment, are government bonds (those issued by others but guaranteed by governments are similarly secure). “The risk free nature of these bonds reflects the ability of governments to continually raise income via taxes to meet their financial obligations,” explains Michel. An awful lot has to go wrong with a country before it starts defaulting on its own bonds. But, correspondingly, these bonds tend to pay much less than other types: a 10-year Australian government bond yield at the time of writing was yielding around 4.4%, and a US 10-year less than 3%.

Next come corporate bonds, issued by a company. Here, your assurance of getting your money back is based on the strength of the company itself. If the company goes under, you’re in trouble. That said, it is useful to understand something called the capital structure which reflects the way companies raise their money. If the company is wound up, bond holders get paid before equity holders, who may well be wiped out completely. There are further distinctions too: some issuers (banks are the main example) issue both senior debt and subordinated debt. In this case, in the event of the company getting into trouble, the senior debt holders are paid first, then the subordinated debt holders. Consequently, the subordinated debt tends to pay a better return to reflect that risk.

Corporate bonds cover a multitude of financial strength. There are companies out there with higher ratings than many national governments; there are others who are so risky that their bonds attract the term “junk bond”, or, to use the more polite modern parlance of investment banking, “high yield”, which strictly speaking refers to any bond with a rating lower than BBB- from Standard & Poor’s, one of the rating agencies who assign ratings to reflect the creditworthiness of companies and their bonds.

Then there are hybrids, very common in Australia. These combine characteristics of bonds and shares. Usually, they start out life as a bond, and in certain circumstances – sometimes pre-set, sometimes decided by the company that sold the bond – turn into shares. Companies like them because they offer lots of flexibility with their capital management, and investors have tended to like them because they pay a high yield while they are in their bond form, and are in most cases very easily bought on the Australian Stock Exchange.

On top of that, there are of course many more bond issuers out there beyond our shores, and the international debt markets are deep and sophisticated.

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