In this part of the project, we’re going to focus on some types of investment not well known in the Australian community generally. Many people are aware of term deposits, government bonds and annuities as income generating investments. In fact, they are great, safe investments with minimal risk.
In our project, we’re going to be looking at some higher performing investments such as bonds and bond funds, peer to peer lending and marketplace lending. While these are all generating higher rates of return than term deposits and government bonds: they all entail a different level of risk. That level of risk varies, but be aware that it exists, it can be substantial and you need to make your investment decisions accordingly.
Bonds and bond funds: a long running bull market
Any regular reader of the Constant Investor will know there has been a long-standing rally in the market for bonds. Commentators vary on what this means, but range from “the end of the rally is coming” to “don’t fret too much”. The moral of this story being, if you put any two economic commentators in a room you get 3.7 opinions and an argument about whether opinions can be considered in decimals. The causes and contributors to this rally offer some insight into investing in both bonds and bond funds, however.
The first of these is an economic environment of low interest, low economic growth and low inflation. “Secular stagnation” as it’s known. Sooner or later this will change, but if anybody had a credible idea of when that will be or what form it would take: the market would have priced it out already. Uncertainty remains and it won’t go away.
The second outcome is that we can expect new bond issues will be made with lower coupon rates than in the past due to the low interest rates, for the moment at least. This means that the yield on fixed rate bonds as a class over all may decrease.
When the economic environment does change, bonds may become less attractive and if that happens, their prices will drop: but their yields to maturity will rise. What this means for the individual investor varies according to your strategy, but it’s worth keeping in mind.
If you find the discussion about bond yields and prices confusing, this simple interactive showing the approximate relationship between bond price and yield to maturity may help. Remember, it’s not an exact calculator, it’s an approximate interactive for educational purposes. For an exact calculator, see here.
Discussions of bond bubbles and bull markets are in a sense no different to discussions of a property bubble or a share market bubble. They happen from time to time and as an investor you need to use your best judgement about where to put your money, why and for how long.
The upshot for small investors is twofold:
- Be clear about your expectations for yield. The highest advertised rate of return may not be the best investment for you because it entails unacceptable risk in your circumstances. Don’t make investment decisions based on a belief that you “should” get an overall return of some figure. Look for the best overall return for the risk you’re prepared to accept in the economic environment you’re investing in right now. Not the one you might have been investing in five or ten years ago.
- Understand the risk profile you’re investing in. A return of 10% in this economic environment bears a different burden of risk than a return of 10% in the economic environment of a decade ago. In general, the current risk is probably greater for that level of return.
Who did we research and why?
We researched a variety of bonds and bond funds. We chose these as exemplars of possible investments available. Whilst corporate bonds themselves are not strictly unlisted investments, we included them because they provide a good comparison for other unlisted income generating investments we’ll be discussing in coming weeks.
Among bond funds we have concentrated on unlisted, managed funds. As an investor, you should also be aware of exchange traded bond funds as well.
This is a very fast-changing environment. This analysis was performed August and early September, 2016. Remember that rates of return and conditions change quickly, so check each provider’s website for up to date details.