Your Window on Investing

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1 Your Window on Investing Diversification Your Best Defence

2 If you pay attention to the financial media, investment is all about shares. But the bond market is just as important. If shares are the sword in your investment arsenal, bonds are the shield.

3 Shares versus Bonds Bonds, like shares, are securities issued by companies, governments and other organisations to raise money for their activities. Bonds are a type of loan. Investors in bonds or debt securities are creditors of the issuer. Investors in shares or equity securities are part owners of the issuer. Buying shares in a company gives investors the right to vote at shareholder meetings and the opportunity to earn a share of the profits. Buying bonds gives investors the opportunity to receive regular fixed interest payments over a set period, after which they are fully repaid. Bonds generally are seen as less risky than shares. If a company fails, bondholders get paid before shareholders. Bonds defensive nature means they tend to offer lower returns than shares over the long term, though they can still beat shares for extended periods. The important point is that each asset class performs differently at different times. So by owning both, you are spreading your investments to reduce overall risk.

4 Bonds as a Buffer Annual Return (%) Why do bonds and shares perform differently? When the economy is strong, investors appetite for risk increases. Asset classes like shares and property can do well at these times. Correspondingly, cash and bonds can provide a safe haven in tougher times. As it is extremely difficult to time these changes, you need to own all these asset classes in your portfolio. We saw this in the financial crisis of 2008 and in other downturns in the past decades. When shares suffered, cash and high quality bonds did well, reflecting the different characteristics of these asset classes. 87 Crash 90 s Recession Asian Crisis Australian Shares Tech Wreck Australian Bonds Global Financial Crisis So bonds can act as a kind of cushion or buffer in your portfolio, reducing the ups and downs and giving you a smoother ride. In this example the Australian sharemarket is represented by the S&P/ASX All Ordinaries Index and Australian bonds are represented by the UBS Warburg Australian Bond Composite Index All Maturities. The time period is January 1986 December By the way, it s very hard to predict whether shares or fixed interest will do better at any one time. That s why the best approach is to own both in a mix that s right for your age, circumstances and appetite for risk.

5 Bonds can be Risky Too Bonds are often described as a safe haven, but like any investment that offers a return, they carry risks of their own. Rising inflation and interest rates reduce the attraction of bonds fixed payments and reduce their price on the open market. As longer-term bonds are more sensitive to this maturity risk, staying in shorter-term securities offers some protection. But staying in cash all the time is not a good strategy because when interest rates are falling so do your returns. The answer is to invest in a diversified fixed interest strategy where maturities vary depending on where the best opportunities are. Return 0 Term of Loan (Maturity) Optimal opportunity Extend maturities when there is an 5 10 Return Optimal opportunity 0 Term of Loan (Maturity) Reduce maturities when longer securities The anticipated second reward. risk with bonds is that the borrower do can t not provide repay additional the loan return. and you do not get your money back. This is called credit risk. Credit risk can be dealt with by carefully selecting bonds from a range of issuers. A more defensive strategy would be to stick to the most creditworthy issuers, like governments and blue-chip companies. A less defensive one would be to seek greater expected return by taking on additional credit risk Investing in international bonds adds further protection by giving your portfolio exposure to many different economies.

6 Bonds Other Benefits So bonds make your portfolio more diverse. And diversifying within bonds, across maturities, issuers and countries further spreads the risk. But there are another couple of often neglected reasons for having bonds in your portfolio: First, bonds should provide a long-term premium over cash, although keep in mind that this premium is not always there. Second, bonds should be a source of liquidity in your portfolio. That means they can be easily converted to cash if needed. The crisis of 2008 hurt just about everyone. But the pain was greater for those who had invested in fixed interest assets that they couldn t sell easily. By making income their major focus, they ended up with high yield (and high risk) assets. When the crisis hit, these complex, illiquid securities provided no defence against losses in shares. But handled the right way, bonds can play important roles in your portfolio as a diversifier, in providing a premium over cash and as a source of liquidity. They really can be your best defence.

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