A Bond is simply defined as a loan made by an investor to a borrower, where a person who invests in a bond is a debt holder and the issuer of the bond makes a promise to the investor to pay a pre-determined interest rate (bond yield), for a set period (term of the bond) and then usually (hopefully) they pay back any amount owing return of capital. In very simple terms, a term deposit is like a bond – you provide a bank with a sum of money – they agree to pay you an interest rate for a set period of time and then they promise to return your original money back to you when the term deposit period ends.
You can invest in bonds that a bank offers (like the term deposit example), or bonds that a government offers, or bonds that many ASX listed company offers, known as corporate bonds or ASX listed income securities. The broad rule of thumb with bonds is pretty simple – the more risky the issuer of the bond (or less likely the issuer will pay back your money), the higher the yield on offer. The Bond market is how governments and large companies can borrow money to finance their activities – an investor in bonds in essence a lender to the government or company who has issued the bond.
Bonds are normally used in a portfolio as a defensive asset – they preserve capital value, generate an income and provide a buffer within a portfolio when shares and property may be falling in value.
Bonds and interest rates
Bond rates both in Australia and globally have been declining in recent years and are currently at record all time lows. The graph below (source: Reserve Bank of Australia website) shows the applicable interest rate or yield on a 10 year Australian government bond over the last 20 years – which as you can see has been falling steadily from around 7% in early 2000 down to as low as 1% in recent times.
The reason bonds and bond yields have been in the news a little recently, and may start making more headlines, is longer term bond yields are rising, (admittedly from a very low base). With a post pandemic economic recovery starting to gain momentum across the world, there is some concern over rising bond rates and rising inflation and the impact these higher bond rates may have on the global economy. These factors may potentially impact investment markets – and as the concerns over the pandemic are reducing, the developing worry seems to be rising bond yields and rising inflation. At some stage it is to be expected that interest rates will begin to rise, but knowing when this may occur is very difficult (impossible) to predict – it may be a few months, a year or two or even longer.
What to do in a low interest rate world?
This is the question many investors are presently asking. When the cash rate is 0.10% and an attractive 1 year term deposit at a major bank is paying 0.50%….what is an investor to do with their cash holdings? The following are a few comments often discussed when this conversation comes up.
- Lower your return expectations – when the cash rate was running at 5%, say 10 years ago – expecting an 8% average return on a standard “balanced” portfolio was quite realistic. With the cash rate now at 0.10% – it is likely that meeting an 8% average return may be much more difficult.
- Review your investment risk profile and the level of defensive assets you are holding in your portfolio. If low returns are a worry and you are not comfortable reducing your return expectations, then you may need to invest more funds in “growth assets” like shares and property to aim for a better (potential) long term return. Just remember the risk/return trade off….holding more growth assets in a portfolio means higher the level of volatility.
- Watch out for “high yield” offerings on fixed interest investments. High interest / or high yield offers usually also mean higher risk.
- Consider the likely yield on either property investments or divided paying shares – both are currently much more attractive on an income basis compared to cash.
- Lastly, remember inflation and its impact on your cash holdings – especially when the cash rate is much lower than the inflation rate. Inflation reduces the real value of your money – so $100,000 of cash today would only be worth $99,000 in 12 months time, (based on the a current 1% annual inflation rate). Assets that can appreciate in value over time (like property and shares) will reduce the negative impact inflation has. Obviously cash and term deposits offer perceived security via capital stability (and often a government guarantee), but don’t forget that over time, inflation is slowly chipping away at the real value of your cash funds.
As I have mentioned to many clients in recent times – while cash rates are so low there is a lot of money moving out of cash and into shares, property and other types of growth investments – which may continue for some time. There is always a place for cash within a portfolio and having an easily accessible cash reserve is very important for peace of mind – but in the current low interest environment, many are understandably weighing up their options.