Why bonds are attractive for SMSFs

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I am delighted to be contributing to the Switzer Super Report as I’m passionate about spreading the word about bonds.

Because of its complexity, many investors are unsure about the fixed income asset class (which includes bonds), which is huge and on a global scale – five times the size of the global equity market! My aim initially is to get you up to speed on this market, while at the same time discussing opportunities to buy and sell.

Fixed income includes investments such as At Call Accounts, Term Deposits, Bonds and Hybrids. I expect all of you will have an At Call Account or a Term Deposit, but it’s worth taking the time to understand other securities available as they have unique properties that can help you achieve your investment goals.

So, how do bonds differ from shares?

Bonds are simply a loan from you – the investor – to the government, company or bank who issues the bonds. Importantly, they are a contractual agreement and as such, the issuer of the bonds must pay interest (known as the coupon) when it’s due and principal according to the terms of the agreement. In that way investors who purchase bonds know what their income will be and in most cases know when they’ll receive their capital back (see Figure 1 below).

So, bonds have that certainty of income and capital repayment in contrast to shares (equity) where dividends can be cut and the price of shares can fall, meaning investors can never know their return until they make the decision to sell.

Figure 1.

Bond investment is altogether different than equity investment. Since a bond is a legal agreement and the company issuing them must make coupon and principal payments, investors’ primary focus is the ability of the company to survive. It’s much easier to choose a company that you expect to survive than one which will grow.

Leighton: stocks or bonds?

Take Leighton Holdings as an example. They’ve made some poor tender bids that have cost the company and it’s been forced to revise profit forecasts. The share price has been a roller coaster (the share price high in the last 52 weeks was $26.65 and low $14.71 with a last trade of $17.24). Yet the company is supported by a significant amount of pending work. It is somewhat easier for an investor to judge whether Leighton is likely to survive based on the strength of its order book than it is to predict what will happen to the share price.

Over the past 12 months, Leighton’s share price fluctuated by 45% from its peak to its low. Over the same period, Leighton’s senior

Australian dolla fixed rate bond price peaked at $107.58 and its low was $105.07, showing a price movement over the same period of just 2.3%. Much of the reason for Leighton’s bond price movement was due to lower interest rates and had nothing to do with the perceived risk of the company.

The bottom line

In summary, bonds provide a consistent return and with capital repayment at maturity (in the vast majority of cases). The fact remains that bonds are lower risk and display less volatility than shares.

Leighton’s bond is a fixed-rate bond maturing in July 2014 and is currently trading at a premium of $107.08 per $100 face value. The yield to maturity (which incorporates the loss of face value as the bond will only repay $100 at maturity) is 5.30%. However, the running yield is much higher at 8.87% and this high income stream will appeal to some investors.

While the capital loss may make the bond less attractive, investors are still willing to buy the bond to lock in the fixed rate for the defined period, especially given recent interest rate cuts and lower prospective term deposit rates.

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.

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