Is it time for SMSF Trustees to seriously consider investing in bonds/credit funds for income?

Is it time for SMSF Trustees to seriously consider investing in bonds/credit funds for income?

October 2019

For investors, it’s become the new “barbeque stopper” – where to find yield with a cash rate at one per cent and the Reserve Bank dropping hints like confetti that it’s more than willing to cut them again to stimulate the economy.

It’s not hard to understand why, with three factors standing out. The first is obvious. Low inflation and spluttering economies have prompted central banks to continue vigorously wielding monetary policy, with the net effect being record low interest rates and bond yields, with the flow-on effect to bank deposit rates. Putting your money in the bank is hardly the answer for anyone wanting income.

Second, it appears while investors are skittish about markets (especially equity), they seem to be largely inured to the prospects of another crash. Having survived the Global Financial Crisis and the subsequent ongoing dramas about Europe’s public debt, they seemed prepared to take more risk to lock in yield.

The third reason is demographic. In developed countries, in particular, baby boomers – the generation born after World War 11 – are retiring, and many will live well into their 80s and 90s. In Australia, it’s estimated that the population aged 65 and above will rise from 15 per cent today to 22 per cent by 2061.

So, it’s understandable they are looking for two key features in their investment portfolios – capital security and yield – with growth, for many, being an added extra. In the distant past, cash and term deposits would have provided the simple answer, but that’s simply not possible today, even if the inflation genie is well and truly in the bottle with the lid firmly on.

Now, there are many ways to get yield, but this article is looking at government and corporate debt, with the former typically called bonds and the latter credit.

With some exceptions neither form of debt has been popular with Australian investors, in stark contrast to many other developed economies where government bonds, in particular, have been seen as at least offering capital security.

Self-managed super funds (SMSFs) – especially those in retirement phase – might be expected to invest in credit and bonds (especially the latter), but it’s not the case. At 31 March 2019, ATO figures show only $11 billion of total SMSF assets of $746 billion in this asset class – a miserly 1.5 per cent. [By contrast, cash and term deposits stood at $171 billion or 23 per cent.]

Government bonds from wealthy developed nations, including Australia, are considered by the market to be virtually risk-free in terms of credit quality, with their yield only reflecting duration risk (that is, the risk of interest rates rising, pushing down the bonds’ price). These countries have the common ability to be able to raise taxes, so markets expect them to be able to meet their obligations. Obviously, the yield lengthens for bonds from less developed countries where corruption and tax avoidance are issues. Some countries have long histories of defaulting on bond issues.

For companies that issue corporate debt to raise capital, they will have both credit and duration risks. The latter is no different to bonds – rising interest rates will push their prices down*. Their credit risk directly relates to the profitability of the company. If a company is making good profits, then its capacity to meet its financial obligations increases, pushing up the price of its debt. Conversing, a company struggling will see the price of its credit fall.

The risk for investors is if a company cannot meet its obligations to make coupon payments before the credit issue matures, causing it to default. If this happens, investors in the debt issue risk losing all or part of their principal, depending on what can be recovered from the company issuing the debt.

The corporate debt market in Australia is small. Most big Australian companies that make credit issues do so overseas, another reason why this debt market attracts little investor interest.

However, that investor attitude is changing via one instrument, in particular. There are a number of ETFs on the market that have bonds and credit as the underlying securities. They can be either passive (simply reflecting a market index) or active (where managers back their investment skills to be able to outperform the index).

In a period when cash and term deposits are at historical lows (and likely to go lower), investors should consider corporate debt and governments bonds. But they should consider getting specialist advice before doing so. Expert fund managers can get it wrong, so for novices getting advice should be a pre-requisite. If you do so, then this is an asset class that can provide income and capital security.

*When interest rates rise, the price of bonds falls. But when interest rates fall, the price of bonds rises.

 
 
Written by Per Amundsen, Head of Research, Thinktank
 
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