Bonds or Shares?

Despite being one of the four mainstream asset classes, bonds are often overlooked by Australian investors by both retail ‘Mum and Dad’ investors; and Institutional investors such as industry and retail superannuation funds.

The bond market combined, also referred to as fixed income or debt-securities, is estimated to have a nominal value in excess of $100 Trillion dollars.

So, why is this buoyant and often compelling asset class so foreign and neglected by so many?

One of the reasons behind this, especially if you are Australian; is because investors have typically had their investment monies preoccupied with the likes of physical property and ASX-listed direct shares; alongside a fundamental lack of education and apathy towards this area. Hopefully you are not already yawning!

Before discussing further, a simple definition of a ‘bond’ is a normal loan, often made to a corporation or Government, with this so called ‘debt-issuer’ promising to repayment these monies back at a pre-determined moment in time, often with periodical ‘coupon’ payments made along the way. Henceforth and for all intensive purposes, this is no different to lending money to a friend or family member.

The issuer of the bond will then use the monies during the investment time horizon, until maturity, to invest into their business or put towards the costs of running a country!

Back to the fundamental question, how is this different from the likes of a public company issuing equity (shares), either at Initial Public Offering and subsequent to this, via a Right Issue? International readers: this is the same as a Seasoned Equity Offering. 

Firstly, debt-holders, that being the investors into the bond securities, do not have voting-rights; which is one of the reasons why a company’s Treasury will issue bonds over equity; otherwise being ownership which can attract voting rights. (expect tip: see definition of the different classes of shares available). This may not be desirable to the existing shareholders, that being the dilution of their current ownership and with it voting rights.

Secondly, as bond-holders rank ahead of shareholders in the event of a corporate failure (think Enrol circa 2001); the coupon payment made out to investors is often lower than the returns requested by shareholders. This linear relationship between risk and return is very visible, taking the example of the U.S. Government currently able to issue bonds (i.e. borrow money) for a measly 0.16% over a one-year time period (source: U.S. Department of Treasury). Would you otherwise feel compensated investing into stocks promising a dividend return of 0.16% at the moment?

So, with portfolio safety in mind, many investors incorporate bonds into their overall asset allocation; providing both downside protection and an overall reduction in the volatility of their portfolio. This reduction in volatility (i.e. risk) can be proven beyond any doubt by comparing the standard-deviation of a portfolio which holds investment grade bonds alongside equities, with another portfolio which is exclusively holding stocks, holding all else constant. Software tool EViews is a great way to look at this yourself, in the event you can obtain a clean data-set.

So, with it now determined that bonds are typically less risky and with a lower investment return expected by this; which is better for you: bonds, stocks, both or neither?

That depends entirely on your own investor preference, risk appetite and a dozen other factors. Many of our clients hold portfolios which invests in a combination of these two asset classes and for a wide variety of reasons.

Before making this decision, an investor needs to assess their long-term capital growth expectations; yield requirements; taxation structure; current income; income stability; sequence risk and overall risk appetite.

This decision is no less important than being able to distinguish between ‘investment-grade’ and ‘non-investment grade’ bonds, as these are also polar-opposites.

Either way, happy investing and let us hope you don’t have your money in the next Enron, bonds or shares alike.  

Written by Brett Jackson (M.App.Fin., B.Com., DFP)          

Director, Lantana Private Wealth

Brett has lectured at the post-graduate level, tenured as a Scholarly Teaching Fellow at Monash University.

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