Achieving a sufficient and predictable income stream in retirement without taking on too much risk and how to adequately diversify a portfolio are two issues that can be relevant to SMSF investors.
Diversification into fixed income - or bonds - can present some hurdles.
Wholesale bonds are usually bought in minimum $500,000 parcels, outside the capacity of most SMSFs.
While there are specialist fixed income providers who offer a range of bonds in smaller parcel sizes, it might still be an asset class and purchase process that seems ‘unfamiliar’ to some trustees.
Bonds offer investors a known income stream (coupon) and a known outcome at maturity (face value of bond) with generally lower volatility than shares or hybrids. Volatility is the measurement of the fluctuation in a security's value over a period of time.
While investors have had access to fixed income as an asset class through managed funds, exchange traded funds (ETFs) specialising in corporate and government bonds have created a new alternative for obtaining this exposure. Access through a exchange gives you a simple and affordable way to diversify your portfolio, allowing you to buy and sell like any other listed security.
It’s important to note that one key difference with ETF or managed fund exposure to bonds as opposed to owning a bond outright is that ETFs and managed funds don’t mature and return capital at a specific date as a regular bond investment might.
To bridge this gap investors now have the option of exchange traded bonds (XTBs).
XTBs might be suitable for SMSF trustees:
- looking to boost the defensive part of their investment portfolio
- wanting capital stability and fixed income
- who want a better yield than term deposits offer
- who are prepared to accept the additional risks involved in investing in corporate bonds
XTBs combine the predictable income and capital stability of corporate bonds with the transparency and liquidity of the exchange and, because investors buying XTBs are purchasing units in a trust that has exposure to a single corporate bond, the full face value of the investment is returned in cash when the bond matures.
“That is a very, very critical distinction from managed funds, ETFs and hybrids,” says Richard Murphy, the Australian Corporate Bond Company co-founder and chief executive.
Know what you are getting
“With XTBs, you know on the day you invest what your coupon will be at regular intervals and you know when you should get the $100 principal returned,” Murphy adds.
XTBs were introduced to the ASX in 2015, giving retail investors a new way to access this asset class. “XTBs give all the economic characteristics of a bond, without you actually owning the bond. The bond is sitting in the listed trust that issued the XTB,” says Murphy.
XTBs can make periodic interest payments to the owner. This could be at a fixed coupon rate or change in line with a specified, known benchmark interest rate. Either might be a better rate than a term deposit yield.
What are the risks?
Credit risk and the risk of interest rate increases are two considerations.
As a creditor lending money to a company, you are in front of shareholders for any return if the company goes into voluntary administration, but there is no guarantee you would get your money back if that happened. Murphy adds “As XTBs cover investment grade bonds, the global historical recovery rate published by S&P when a corporate does default has been 50% for senior bonds.”
If interest rates rise, bond prices go down, and this can become an issue if you needed to sell your XTB before it matured. But if you hold to maturity, it doesn’t matter what happens to rates as the bond matures at $100 anyway.
But Murphy says that, “other than simply buying and holding, there are ways to reduce interest rate risk, including buying a basket of fixed rate bonds with one maturing each year (allowing you to take advantage of rate increases), or investing in floating rate bonds”.
“Floating rate coupons go up when interest rates go up so they're not impacted at all by interest rate changes,” he explains. It should be noted that the reverse applies if interest rates move down.
If you want more information about how bonds might work in your portfolio, you should talk to your financial adviser or you could contact CommSec Advisory.