Alan Clarke is an authorised financial adviser with 24 years’ experience in the finance sector
With global economies and share markets remaining in a state of flux, investors have been increasingly turning to bonds for yield and/or as a safe haven.
What about gold as a safe haven? Gold prices have risen sharply during the past two years, but its price can also fall equally fast. Hardly a safe haven; rather a highly speculative asset. However, it may have a place as a hedge against all sorts of calamities, but it is probably best not to have more than five percent of your money in it.
So back to bonds. During the past two years bonds have been far and away the most popular asset class, because bonds – good quality bonds – have been solid and steady. It is clear that they are popular for two somewhat different reasons: that of a safe haven and/or steady yields – albeit lowish and boring yields.
A bond is a usually a loan to a government, an SOE, or a big, corporate, company.
Bonds generally will be for a five year term, carry a fixed rate and have a rating. There are other bonds that reset the interest rate annually and some are perpetual and never mature. Unless you know the bond market well, it is better to stick to five year bonds that pay a fixed rate and have a known maturity date.
Bonds can be bought when issued, or can be bought from other investors. Global bond markets are twice the size of global sharemarkets and millions of bonds are traded daily around the world.
But as always there are very good bonds, good bonds, average bonds, and junk bonds. Ratings might be AAA, AA, A, BBB, BB or B, and anything higher than BBB is investment grade. Don’t go below BBB or buy unrated bonds unless you really know what you are doing!
As with all investments, bonds do not offer a ‘free ride’ – the higher the return, the higher the risk. If you want a ‘safe haven’, you must seek quality first and put yield second.
Interest rates are impossible to predict, and since you don’t want all your money maturing at the same time, a bond portfolio should have differing maturity dates; some maturing in 2012, some in 2013, some in 2014, some in 2015 and so on.
Bond prices can rise and fall and the pricing mechanism mainly depends on interest rates:
If interest rates rise, the price will fall*
If interest rates fall, the price will rise*
* This only matters if you want to sell before maturity.
Bonds in NZ are currently expensive (lowish returns) due to high demand and a lack of new issues. Hence an investment in a $10,000 BNZ bank AA rated bond paying 8.675 percent and maturing in 2015 would cost about $11,000 today. This is a $1,000 premium you would not get back if held to maturity, although any such loss is tax deductible. The better option is new issues but very few are coming to the market.
What about global bonds?
The global economic infrastructure is in much better shape than it was in 2008. When the GCC hit, many companies restructured and became as ‘lean & mean’ as they could, and are many are very profitable. In addition they have been very prudent and US companies are holding on to an estimated $2 trillion in cash reserves.
With many corporates in such good shape, investors and fund managers are already tilting their bond portfolios away from shaky governments to corporate bonds, which makes a lot of sense.
But how do you access these from little old NZ? Our favoured global bond fund is the DFA 5 Year Fixed Interest Trust which is spread across 80 to 90 AAA and AA rated global bonds, so has excellent diversification and is very low risk.
The fund is hedged into NZ dollars, so is unaffected by the exchange rate. The average return has been 7.5 percent pa since inception in 2004, and has been about 6.5 percent during the past year or so. Whilst it is known as the five year fixed interest trust, this only relates to the maximum duration of the investments they hold, and funds can be withdrawn at any time.
Bonds in summary
If bonds appeal to you, buy a mix of NZ bonds and the DFA fixed interest funds. Take care in selecting a portfolio of bonds, as a properly designed portfolio will always be better than a portfolio put together in an ad hoc manner.
As always – diversify widely, on and offshore.
