Equity derivatives provide an opportunity to seek enhanced income returns from share investments, while managing risk and providing portfolio hedging
Bonds are a great source of predictable income and a key part of an investment portfolio
A key purpose of a bond is to create a stable income source. However, bonds also play an important role in creating portfolio diversification and generally lowering portfolio risk.
Bonds offer access to predictable cash flows by way of regular interest payments, known as coupons. Some also can protect real purchasing power with returns that exceed the inflation rate. Bonds also offer the potential for capital gains if the value of the bond increases, and you decide to sell it.
This is important to note, as even if you buy a 10-year bond, you are not locked into holding until maturity. You can sell bonds of all tenors.
The reason people buy bonds on the secondary market is because unless the bond issuer defaults, investors know they will get the face value of the bond at maturity.
This raises another point. There are many types of bonds, ranging from government bonds to investment grade corporate bonds, high yield bonds, hybrids, convertible notes – the list goes on.
Each type of bond carries different risks, and even within a type of bond there can be variations on the terms and conditions of a particular issue. Before making any investment decision, it’s important to understand what events could impact your investment, and what protections you have if an event occurred. All of this can be discussed with your NAB investment specialist.
A well-structured investment portfolio that is focused on growth will still have a percentage of the portfolio in bonds. This is because bonds offer diversification as they are driven by different forces to those moving property prices or the share market. Historically, bonds are not as impacted as shares during times of crisis.
Generally, a portfolio focused on growth will have a larger weighting to assets like shares and property, while one focused on income and wealth preservation will have a larger weighting to assets like term deposits, gold, and bonds.
Another path of diversification is to hold assets in different countries and regions and in different currencies, and bonds can excel at this.
Who issues bonds?
Typically, bonds are issued by companies, governments, or public bodies as an alternative to other forms of funding, like bank loans. Bonds sit on the debt side of the balance sheet, and therefore are higher ranked than shares for a return of capital in the event of a corporate collapse.
Companies pay dividends, so why bonds?
Certainly, share dividends can be a component of the income side of your portfolio, however, there are significant differences in performance to bonds.
Firstly, your interest payments and frequency of payment on bonds are locked into the terms and conditions. Share dividends depend on the performance of the company, and as we saw during the early stages of the pandemic, banks had a cap on dividend payments placed on them by the regulators to ensure they retained funds for any emergency.
Share dividends are also more influenced by the boom-bust economic cycle.
From an income perspective, consider a resources stock over 10 years. It may pay high dividends during a resources boom but lower dividend payouts or even put dividends in abeyance during a downturn. In comparison, bonds with that same company would have interest payments locked in throughout the period.
It highlights that as we seek to smooth out long term returns, bonds have a role to play.
Strategies for long-term investors
In any environment, there will be companies and sectors that present opportunity. Depending on your investment timeframe, some sectors are particularly relevant to the longer term.
This is because you can take advantage of secular trends, such as digital disruption and environmental, social and governance (ESG). An expanding area of the Australian credit market is in bonds linked to social and environmental outcomes. The Australian ESG bond market has been growing, and with the entrant of big corporates, this is a game-changer as corporate bond yields are typically higher than the more typical offering of semi government bond. This is a market that is set to increase rapidly. In global markets, ‘investing with impact’ is getting record traction.
What should investors do
Investors should ensure they have well-balanced portfolios to navigate market cycles. Income-seeking investors should consider holding bonds in a portfolio.
There are strategies for every situation and many avenues for investors to consider in addition to corporate grade bonds. Those seeking to mitigate an exposure to interest rates movements could consider lower duration bonds or hybrids, contingent capital notes and high yield bonds, all of which tend to be more sensitive to the macroeconomic environment and company financials than to interest rates. They also typically offer higher coupons but carry higher risk. If you are interested in these types of products and want to understand the associated risk, talk to your NAB Investment Specialist.
The information contained in this article is gathered from multiple sources believed to be reliable as of the end of September 2023 and is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. Before acting on this information, we recommend that you consider whether it is appropriate for your circumstances and that you seek independent legal, financial and taxation advice before acting on any of this information. ©2023 NAB Private Wealth is a division of National Australia Bank Limited ABN 12 004 044 937 AFSL and Australian Credit
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