Why you should invest in bonds
It feels like 99.9% of media coverage on investing is about stocks. However, any good book on investing will advice you on investing in bonds as well.
So, what are bonds? Why should you bother with them?
Investing in a bond is like being a bank to governments or large companies (the borrower). The bond investor receives interest payments from the borrower. Interest is usually paid twice a year. For a full definition see here.
The key benefit of investing in bonds is diversification. Bonds are negatively correlated to the stock market. This means when the stock market tanks, the bond market will do well. This will make your portfolio less risky and more stable.
This chart shows the returns of the stock market vs the bond market in the last 20 years. In that time, the stock market went into negative (ie loss money) in 5 out of 20 years. In those 5 years, the bond market did well.
In particular, look at the 2009, when the GFC hammered the stock market. The stock market was down by 20.1% but the bond market was up by 10.8%.
Of course, like all investments - lower risk leads to lower returns. Stocks generally provide a higher return over the long term. In the past 20 years, the stock market returned an average of 8.9% p.a., whilst the bond market did 6.6%.
What happens when you add bonds to your portfolio?
To show the impact of adding bonds to your portfolio, let's have a look at two portfolios:
1) Stock Portfolio: 100% stocks, represented by the ASX 200 Index;
2) Diversified Portfolio: 70% stocks (ASX 200 Index) and 30% bonds (Bloomberg AusBond Composite).
Assume you invested $100,000 in each portfolio on 30 June 2005.
Over the last 10 years:
+ Stock Portfolio would grow to $198K, beating the Diversified Portfolio's value of $192K (or by 2.7%);
+ Stock Portfolio would lose money in 3 out of the 10 years, whilst the Diversified Portfolio would lose money in 2 out of the 10 years;
+ Because of the negative years, the Diversified Portfolio ended 5 out of the 10 years ahead in portfolio value.
If you extend this idea all the way back to 30 June 1995 (20-year period), the Stock Portfolio does quite a bit better. But this is precisely the point. Most people invest to grow their money, so they can use that cash later on in life. Maybe the cash is for buying a cool car, putting kids through private school, etc.
If you plan to use the cash in a shorter period of time, you need to consider the value of the portfolio at different points in time.
Say you need the money 5 years into the investment period. You'd have to sell the stocks / bonds. The Stock Portfolio would be worth $125K. This is $3K less than the Diversified Portfolio. By owning bonds in your portfolio, you reduce the price fluctuation across time.
How do you invest in bonds anyway?
There are lots of options to invest in bonds. You can buy Australian Government Bonds from the ASX.
The Australian Corporate Bond Company introduced Exchange Traded Bonds (XTBs) to the Australian market this year. XTBs allow you to buy direct exposure to bonds issued by large companies like Telstra, Woolworths, Wesfarmers, BHP, etc.
At BetterWealth, we are strong advocates of Exchange Traded Funds (ETFs). There are a few bonds ETFs. The largest is Vanguard Australian Fixed Interest Index ETF (VAF), followed by iShares Composite Bond ETF (IAF).
Both VAF and IAF track the Bloomberg AusBond Composite Index. This means that investing in them is like investing in a strong portfolio of bonds. The chart above shows the bonds IAF owns as at 30 June 2015. As you can see, more than 80% of the fund is government bonds.
Drop us a note about your experience in bonds investing. We are particularly keen to know about the balance between stocks and bonds allocation.