Your Window on Investing

Diversification

Your Best Defence

“If you pay

attention to the

financial media,

investment

is

all about shares. But

the bond market is just

as important. If

shares

are

the

sword

in your investment

arsenal,

bonds

Bonds

Shares versus

Bonds, like shares, are securities issued by companies, governments and other organisations to raise money for their activities.

Bonds are a type of loan. Investors in bonds or ‘debt’ securities are creditors of the issuer. Investors in shares or ‘equity’ securities are part owners of the issuer. Buying shares in a company gives investors the right to vote at shareholder meetings and the opportunity to earn a share of the profits. Buying bonds gives investors the opportunity to receive regular fixed interest payments over a set period, after which they are fully repaid.

Bonds generally are seen as less risky than shares. If a company fails, bondholders get paid before shareholders.

Bonds’ defensive nature means they tend to offer lower returns than shares

over the long term, though they can still beat shares for extended periods.

The important point is that each asset class performs differently at different

times. So by owning both, you are spreading your investments to reduce

overall risk.

Why do bonds and shares perform differently?

When the economy is strong, investors’ appetite for risk increases. Asset classes like shares and property can do well at these times. Correspondingly, cash and bonds can provide a safe haven in tougher times. As it is extremely difficult to time these changes, you need to own all these asset classes in your portfolio. We saw this in the financial crisis of 2008 and in other downturns in the past decades. When shares suffered, cash and high quality bonds did well, reflecting the different characteristics of these asset classes.

So bonds can act as a kind of cushion or buffer in your portfolio, reducing the ups and downs

and giving you a smoother ride.

By the way, it’s very hard to predict whether shares or fixed interest will do better at any one time. That’s why the best approach is to own both in a mix that’s right for your age, circumstances and appetite for risk.

a Buffer

Bonds as

In this example the Australian sharemarket is represented by the S&P/ASX All Ordinaries Index and Australian bonds are represented by the UBS Warburg Australian Bond Composite Index All Maturities. The time period is January 1986– December 2010. Annual Return (%) -50 -30 -10 10 30 50 70 1986 1989 1992 1995 1998 2001 2004 2007 2010 87 Crash _{90’s Recession} Tech Wreck

Asian Crisis _FinancialGlobal Crisis Australian Shares Australian Bonds

be Risky Too

Bonds can

Bonds are often described as a safe haven, but like any investment that offers a return, they carry risks of their own. Rising inflation and interest rates reduce the attraction of bonds’ fixed payments and reduce their price on the open market.

As longer-term bonds are more sensitive to this ‘maturity risk’, staying in shorter-term securities offers some protection. But staying in cash all the time is not a good strategy because when interest rates are falling so do your returns.

The answer is to invest in a diversified fixed interest strategy where maturities vary depending

on where the best opportunities are.

The second risk with bonds is that the borrower can’t repay the loan and you do not get your money back. This is called ‘credit risk’. Credit risk can be dealt with by carefully selecting bonds from a range of issuers.

A more defensive strategy would be to stick to the most creditworthy issuers, like governments

and blue-chip companies. A less defensive one would be to seek greater expected return by

taking on additional credit risk.

Investing in international bonds adds further protection by giving your portfolio exposure to many different economies. 10 5 0 Term of Loan (Maturity)

Extend maturities when there is an

anticipated reward. Reduce maturities when longer securitiesdo not provide additional return. 10 5 0 Term of Loan (Maturity) Optimal opportunity Optimal opportunity Return Return

Your W indo W on investing Your B est de Fen C e

Other Benefits

Bonds’

So bonds make your portfolio more diverse. And diversifying within bonds, across maturities, issuers and countries further spreads the risk.

But there are another couple of often neglected reasons for having bonds in your portfolio:

First, bonds should provide a long-term premium over cash, although keep in mind

that this premium is not always there.

Second, bonds should be a source of “liquidity” in your portfolio. That means they can

be easily converted to cash if needed.

The crisis of 2008 hurt just about everyone. But the pain was greater for those who had invested in fixed interest assets that they couldn’t sell easily. By making income their major focus, they ended up with “high yield” (and high risk) assets.

When the crisis hit, these complex, illiquid securities provided no defence against losses in shares. But handled the right way, bonds can play important roles in your portfolio as a diversifier, in providing a premium over cash and as a source of liquidity. They really can be your best defence.