Why bonds are in great demand

Experts suggest the best time to invest in bonds is when fear and panic are high in investment markets, which is what’s happening right now.

This presents investors who have been patiently waiting with cash on the sidelines with an opportunity to buy high-quality bonds at discounted prices. The right mix of these assets in a portfolio can provide relatively stable returns with a low probability of capital loss over the longer term.

While history is no guarantee of future performance, investors who have bought bonds during or after market corrections have typically been rewarded with solid returns.
“Look to be a buyer of the right assets through this period, not a seller,” says Pete Pennicott, a director of financial advice firm Pekada.

“We are in a world of ultra-low interest rates, so finding income is a competitive battleground. If you can sift through the noise, bonds offer value because fear is leading to indiscriminate selling,” he adds.

This is especially the case with corporate bonds.

Prices have dropped as investors have been worried, in some cases rightly so, about the risk of corporate defaults. But there has been a level of overreaction, which is producing very interesting opportunities for investors.

“Markets tend to overshoot on the upside and downside. Being selective on quality at the moment can provide a good entry point, as in many cases all bonds are being wrongly tarred with the same brush,” he adds.

It’s essential for investors to fully understand the bonds they are buying. The risks with individual bonds and also bond funds can vary greatly, depending on the company issuing them, interest rates, credit quality, liquidity and currency.

So bonds issued by airlines such as Virgin Australia are likely to be much more risky than those issued by consumer staples firms like Woolworths, which has just announced new five-year and 10-year senior bonds. ASX-listed capital notes are another option for investors looking to diversify away from shares. These instruments have been aggressively sold off.

AJ Financial Planning adviser Alex Jamieson says this is an opportunity.

“You can access this market through Challenger Capital Notes 2, Macquarie Group Capital Notes 4 or with an exchange-traded fund such as BetaShares’ Actively Managed Hybrid Fund,” says Jamieson.

These instruments produce yields of up to 5.7 per cent a year to maturity.

“Many capital notes are trading below their face value of $100. Buying a capital note below its face value provides a combination of capital uplift and income between now and the projected maturity date,” says Jamieson, who explains capital notes can be redeemed at their face value of $100 at maturity.

Although this looks like free money, there are still risks of which to be aware. Maturity risk is one.

Jamieson suggests staying away from capital notes maturing within the next six months.

“The major concern is if they will be redeemed or extended at maturity.”

Investors should also concern themselves with credit risk and ensure instrument providers are well-capitalised during this period. Plus, capital notes often come with a large buy-sell spread. So be patient with entry points and not try to load too large a position into a thinly traded market.

This is because prices can be easily pushed around by enthusiastic investors or overly zealous super funds or asset managers. Listed property is another segment of the market that’s presenting an interesting dynamic, thanks to the stable yield it offers.

Lifestyle Investment Communities, a listed investment company that builds accommodation for retirees, is a good example.

“It’s benefitting from the baby boomer trend to move into retirement villages and is rapidly growing its footprint to respond to this,” says Jamieson.

Still in credit, albeit up the riskier end, are syndicated loan funds.

Scott Fisher, director of professional services firm Asparq, explains the interest rate these instruments deliver is more than a term deposit provides. But you’re also going up the risk curve.

“Syndicated loan funds are considered to be higher risk because you're lending to an entity going outside traditional banking channels.

"So ask questions about why businesses in the fund are happy to pay a higher interest rate. You need a specialised fund manager to review these entities to ensure that, if you lend them money, you're going to get repaid.”

Investments in this category will typically comprise a small part of overall portfolio holdings and be used to provide diversification and a lift when equities are down.
There are plenty of opportunities in fixed income investments often overlooked by investors who are more au fait with shares.

But experts advise investors should be very aware of risks, and really understand what they are buying before entering bond, or indeed, any market.