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What you need to know about bond proxies

What you need to know about bond proxies

Investors are facing record low interest rates, driving them to look for alternatives to provide income for their retirement funds.

While market and economic uncertainty can make government bonds attractive to some investors looking for safety, yields are low or even negative in a number of major economies, including Japan and Germany.

At around 2%, Australia’s long-term interest rates are high by global standards, although the 10-year government bond rate hit a historic low in August 2016.

Under these circumstances, investors looking for capital stability and predictable income in the longterm might need to consider alternatives to cash and government bonds, as those asset classes may not bring the financial outcome you need to achieve the lifestyle you want in retirement.

Shares vs. bonds

Traditionally, investors buy shares for growth and bonds for income.

Shares can generate income through dividend payments, but they will also fluctuate in market value.

Shares carry greater risk than bonds because you are a part owner of the company if you hold shares. The income they might bring can be irregular. Companies do not guarantee dividend payments to ordinary shareholders.

If the business goes into voluntary administration, shareholders are the last in line to be repaid anything they might have invested.

Access to corporate bonds was previously more difficult for self-managed super funds (SMSFs), but exposure is possible through buying and selling exchange-traded bonds (XTBs) on the Australian Securities Exchange (ASX). The transaction is similar in process to buying shares through an online broker such as CommSec.

You can also access portfolios of bonds, including corporate bonds, indirectly via managed funds and exchange-traded funds (ETFs).

As long as the company does not default, corporate bonds can offer coupon payments, providing regular and predictable income in retirement. Generally, they will offer higher returns than cash deposits.

Because you are lending to a company, you are a creditor, so you stand in front of shareholders for any return if the company goes into voluntary administration.

What is a bond proxy?

Bond proxies are shares that are likely to offer predictable returns, and they can sometimes have higher yields than bond market offerings. A true bond proxy ideally aims to grow cash flows over time.

Infrastructure assets, particularly listed infrastructure companies, can offer a revenue stream similar to bonds.

They can include investments such as toll roads, airports, ports and rail facilities and electricity power lines and gas pipelines. Some S&P/ASX 200 examples include Sydney Airports (SYD), Transurban (TCL), APA Group (APA) and Aurizon (AZJ).

Researching a company’s financial data can sometimes give investors a better comparison of the various options available.

The essential nature of infrastructure assets means that revenue can be relatively immune to economic downturns compared with other industry sectors. This can provide investors with a greater level of certainty about forecast income.

Listed property trusts (LPTs), or Australian real estate investment trusts (A-REITs), can represent a defensive asset in a balanced portfolio. They provide exposure to the value of the real estate assets that the trust owns and any capital growth, as well as rental income.

ASX 200 examples include Scentre Group (SCG), Westfield Corp (WFD), Stockland (SGP), GPT Group (GPT) and Goodman (GMG).

What are the risks?

Valuations are high

As more investors recognise that certain stocks have been paying solid, regular dividends and begin using them as bond proxies thinking that this might continue, the demand for those shares increases, which can drive the share price past its fundamental value.

Investors need to question whether the share price is increasing because it is a solid company with strong earnings growth potential and superior operating performance that justifies a higher valuation, or is it based solely on the dividend payments attracting investors, when continuation of that dividend payment cannot be guaranteed, or the dividends look compelling in the current interest rate environment, which may not be sustainable.

What if dividends decline?

If you are making a long-term investment decision for your SMSF, you should be careful about relying on forecast dividend payments for income.

Dividends are paid at the discretion of a company’s board and are based on numerous factors including current earnings and debt, any potential for future earnings, current and forecast market conditions and competition.

While there might be a strong dividend yield now, there is no guarantee of that continuing.

Interest rates

Falling interest rates can spur investment in bond proxies, because the asset price can be closely linked to the bond market, but they also run the risk of suffering when interest rates rise.

While it is not possible to predict when the interest rate cycle might turn, rising long-term interest rates can push the market price of long-term bonds lower.

For bond proxies, investors should understand that companies can sometimes carry large levels of debt and if interest rates were to rise, the cost of servicing the debt also increases. This can be a concern for any investors counting on dividend payments continuing at the same level or increasing.

If a company has to divert funds to pay off debt or pay higher interest rates on debt, there might be less available cash to pay dividends, and that could affect the income your SMSF receives.

This article is intended to provide general information of an educational nature only. It does not have regard to the financial situation or needs of any reader and must not be relied upon as financial product advice. Investors should consult a range of resources, and if necessary, seek professional advice, before making investment decisions in regard to their objectives, financial and taxation situations and needs because these have not been taken into account. Any securities or prices used in the examples given are for illustrative purposes only and should not be considered as a recommendation to buy, sell or hold. Past performance is not indicative of future performance. Commonwealth Securities Limited ABN 60 067 254 399 AFSL 238814 (CommSec) is a wholly owned but non-guaranteed subsidiary of the Commonwealth Bank of Australia ABN 48 123 123 124 AFSL 234945 and a Participant of the ASX Group and Chi-X Australia. While potential SMSF investments have been illustrated within this content they do not represent a comprehensive suite of possible investment products and services within the guidelines pursuant to the SIS Act 1993 with ATO oversight.