NICK BRUINING Q+A: Where do bonds sit as an investment risk, and are they better than owning shares?
Q+A: What are bonds, where would they sit as an investment risk in your portfolio and are they better than owning shares in the current environment of volatility on the ASX?
Question
After listening to commentators talk about the current value of the share market, I am concerned a fall is coming.
As a type of protection, I have heard people talk about investing some of the gains they have made by selling some shares and putting the money into bonds.
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Answer
Bonds are essentially loans taken out by governments and corporations where they borrow money from institutions and the general public.
For example, the Federal Government might want to borrow money to pay for infrastructure projects, and it does so by issuing Australian government bonds. Those bonds will have a “face value” reflecting the principal of the loan, an interest rate paid, and a term for the loan.
The underlying risk of the issuer determines what interest rate needs to be offered to entice investors to take up the bonds.
Bonds can’t be cashed in ahead of time but can be sold in an open market. That introduces a source of volatility because as interest rates and other variables change over time, the bond’s value needs to be repriced in order to make it saleable in an open market.
Risk-wise, a good-quality bond might be described as sitting midway between a bank’s term deposit and owning shares in that bank. For these reasons, a bond’s total return over a period of time might include the interest payment received plus or minus the change in capital value.
Bonds are not restricted to Australian issuers only. Other countries and large corporations also issue bonds, but this exposes you to another variable — currency-exchange risks.
Most capital-stable or conservative superannuation funds will have a very high exposure to bonds, which can be as much as 80 per cent of the total investment portfolio.
Unlike the US, the Australian retail bond market is fairly limited, though there is a number of brokers who trade in bonds for retail investors.
Like a well-diversified share portfolio, managing risk involves spreading your investment across a range of assets, and the same should apply with bonds.
The easiest way is to use an existing exchange-traded fund which can be purchased through your stock broker or to invest via a conventional unit trust investment. Most of the managed fund providers have bond funds you can invest in.
Question
We have been using our financial adviser for many years and his firm was recently taken over by another.
On his recommendation, we set up a self-managed superannuation fund which we have been topping up in the lead-up to our retirement in 2028.
At our last meeting, our adviser made a recommendation to sell up the assets of the SMSF and move the proceeds into a single investment fund which his new firm operates.
We’re a little uneasy about these changes. Do we have grounds for concern?
Answer
Without knowing the specific reasons behind this advice, the recommendation does raise some questions.
The sale of the existing assets in the SMSF will almost certainly generate a capital gains tax event and an associated tax liability. That expense could be significant and needs to be justified against the benefits of the proposed changes.
While in some cases, these taxes can be mitigated by starting an account-based pension, your question does not indicate that this approach was considered.
From what you have described, the proposed changes could see your funds being placed into a fund where the parent firm collects investment management fees. While management fees are unavoidable and must be disclosed to you, I would want to understand who stands to benefit from the new arrangements.
More importantly, how is the replacement fund demonstrably better than your existing investments?
Good financial planners without ties to a financial product manufacturer typically look into a variety of factors before recommending any specific investment fund.
Under the circumstances, you might want to obtain a second opinion from an unrelated financial adviser. It might be $400 to $500 well spent.
Nick Bruining is an independent financial adviser and a member of the Certified Independent Financial Advisers Association
Originally published on The Nightly
