We continue to receive questions from readers about the fixed-income asset class, and this week I will address a common one: why would I buy bonds when I am getting high returns from my term deposits?

This is a great question, and the answer shows how with a little bit of knowledge about fixed income, you can customize your investment portfolio to best suit your needs – which is what self-managed super funds (SMSFs) are all about.

Allocating your assets

First, I think it is worth stating that all investment portfolios should have an exposure to ‘cash’, through a term deposit, an on-line high interest account, or both. However, because of the historic structure of the bond market in Australia, people have tended to think of fixed income as only being term deposits. This has led to very lopsided asset allocations in most investment portfolio’s, reliant heavily on equities, with term deposits making up the rest. This structure proved largely disastrous for people approaching or in retirement when the Global financial Crisis (GFC) hit and has more recently been highlighted a risk of economy-wide instability by highly-respected commentators including Ken Henry, David Murray; and Lindsay Tanner.

In order to reduce risk, they suggest bonds. Bonds represent a ‘middle road’, offering more stability for both capital and returns than equities, whilst offering the possibility of (depending on the bond) stronger returns than term deposits.

Term deposits vs Bonds

In recent times, term deposits have offered fantastic returns driven by a change in banking regulations and external funding trends, and investors have enjoyed the benefits. However, term deposits are very much a one-size-fits-all solution.

Term deposits lock in a fixed return for investors over the deposit period and at the end of the period you get the full amount of your deposit back. Term deposits have a very rigid structure including penalties if, for some reason, the investor needs to access their cash before the maturity date.

Bonds offer more flexibility to investors, allowing them to better match their specific requirements. Some bonds offer a fixed return, much like a term deposit, so investors needing to lock in their income may chose to focus on fixed-rate bonds, whilst other bonds offer a ‘floating’ rate of return, so the returns move up and down with an underlying benchmark, much like a variable home loan, though in this situation you are receiving the floating amount, not paying it.

These bonds may be more suitable for investors who’s income needs will more closely follow interest rates, rather than be locked into a long-term fixed rate. Remember, whilst rates may be falling at the moment, inevitably, they will begin to rise again.

Inflation-linked bonds

A third type of bond is an Inflation-Linked Bond (ILB), these bonds return a specified rate above inflation, so investors concerned about inflation eating into their nest egg, may chose to invest in these.

ILBs see both the capital and the income move with inflation. If you lock away a term deposit for a longer period like five years, when the deposit matures you will only receive your original investment back, so you may, in a low interest rate environment, have effectively lost capital when you take inflation into account. When an ILB matures, the capital has increased by the rate of inflation, so you get your original investment back, plus an amount reflecting the effects of inflation. Inflation-linked bonds are the only pure protection against inflation available to investors.

Equity hedge

Bonds can also be used to offset the effects of the equity markets. When the economy slows, as it is currently, equities generally underperform and interest rates are cut. When this happens, the capital price of fixed-rate bonds increases – this is in part why fixed government bonds last financial year had a 24% return, and is why professional super fund investors include government bonds in their investment mix.

In future weeks I will look at the capital structure and how it works because understanding this can offer opportunities for stronger returns.

As mentioned, term deposits are offering great returns currently, for example, a five year Big Four bank term deposit is returning around 4.50%, while a comparable senior bond from a Big Four bank is returning 4.00%.

However, if you move slightly down the capital structure, to a Big Four subordinated bond, you can boost your return to 5.75%. Am I comfortable with the risk of a Big Four bank subordinated bond? Yes. Would I prefer to earn 1.25% more for my fixed-income investment? Yes. And this is just one of the reasons a little bit of fixed-income knowledge is essential for any SMSF manager.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.