MYTH 1. Shares outperform bonds over the medium & long term.
- It’s widely believed bonds only outperform shares over short time periods, but this isn’t necessarily the case.
- Bonds outperformed shares over the 10 year period to 28 February 2008, and outperformed them in six of the past 20 calendar years.
- This shows investors may not get adequate return for taking the higher risk of shares at various times. Indeed, if their time horizon is less than 10 years, the risk of shares underperforming bonds increases.
MYTH 2. Interest rate rises cause negative bond returns.
- While there have been some periods when bonds have produced negative returns, they generally produce relatively steady & positive returns.
- For a single bond that is held to maturity, there would have to be a default for there to be a loss of capital or a negative total return on the bond. The risk of default is low in Australia.
- Over the past 20 years, the largest negative monthly return from Australian bonds was 3.29% & for shares it was 12.61%. The largest negative calendar year return for shares was 38.4% for shares (2008) & 4.7% for bonds (1994).
- Over the period of our analysis (December 1994 to March 2011), bonds didn’t produce a negative return over a period greater than four months. In contrast, it can take years before shares recover their losses to regain their previous highs, so that rolling one-year returns can therefore be negative for long periods of time.
MYTH 3. Cash is riskless
- While most investors think about risk as being the possibility of not getting their money back, there are other risks involved in investing. For instance, investors who have substantial holdings in cash accounts at their bank are most subject to reinvestment risk.
- They may be happy if rates rise (unless they have term deposits), but will miss out on the gains they would have received if they had held bonds & interest rates had fallen.
MYTH 4. Term deposits are a better investment than bonds.
- This made sense for those with a short-term investment horizon. Over the longer term, however, term deposits have underperformed bonds.
- There is a significant sacrifice of return from investing in term deposits in the long run.
MYTH 5. All fixed income is the same.
- Just as individual bonds have different characteristics, so do fixed income indices & products.
- It is important investors are selective about the risks they want to incorporate into their fixed income portfolio. For example:
- Duration: the average sensitivity of the portfolio to a parallel shift in interest rates;
- Yield curve: how the portfolio is impacted on by a change in the relationship between short-term & long-term rates (non-parallel shift in interest rates);
- Sector allocation: how the portfolio is allocated between government, semi-government & credit securities; &
- Credit selection: the choice of individual credit securities.
- Credit risk management is a critical aspect of bond investment & diversification alone is not sufficient as a mitigator of credit risk.
In summary, the evidence showing there are benefits of having bonds in any diversified portfolio is overwhelming & can contribute greatly in helping minimise the risk of loss & maximise the probability of outperformance.
Source: Daum, A 2011 “Debunking the Myths About Bonds”, IFA, Issue 567, p 23.
Dustin Kavanagh, Daniel Brown, Elliot Watson & Tony Pereira are Authorised Representatives of AXA Financial Planning Limited ABN 21 005 799 977 Australian Financial Services Licensee Licence Number 234663. Principal Address 750 Collins Street GPO Box 2830AA Melbourne VIC 3000.