Updated May, 2020

Bond funds

Bond funds

For an introductory explanation of bonds, have a read of this page – the risk-reward spectrum.

The Funds

Since the plan is to use equities as our growth assets and bonds as the portfolio’s volatility dial and to be sure we have funds available when we need it, we want high-quality, low-risk bonds, generally government bonds from developed countries. Some high-quality corporate developed country bonds may also be acceptable, but it defeats the purpose of a safe asset to use low quality corporate bonds (junk bonds) that are further up the risk-reward spectrum.

Also, because bonds are for safety, it doesn’t make sense for them to be subject to currency risk, so the only bond funds available on the market are Australian bonds and International bonds that are hedged to the AUD.

The main decision points

1. Government bonds vs Corporate bonds and bond quality

Government bonds of developed countries can generally be considered safe because they can always meet their obligations by either taxing the populace more or printing more money.

Corporate bonds, on the other hand, are more highly correlated to stocks – when the economy is doing well and so are stocks, corporations pay their higher coupons on their bonds, and everything is grand. When the economy hits the skids, stocks fall first, and then corporate bonds are defaulted on as companies start to go under.

Aggregate bond funds are a mix of both.

There are two schools of thought when it comes to bonds.

    1. Bonds are for safety, in which case government bonds fit the requirement. Arguably, there’s no need to diversify globally for developed countries with a stable government like Australia.
    2. Diversify into many countries, markets, and bond types so that if there’s a crash in any one market, at least you’re diversified and aren’t hit as hard. Aggregate bonds fit this purpose. The problem with this is that in a global economic crisis, all markets are hit.

Basically –

    • If you use stocks for the risky/growth part of your portfolio, you want bonds for safety, which means government bonds.
    • If you have a low equity allocation with mostly bonds, you often need to juice the returns a little, and you might add some corporate bonds to replace the function of equities.

If you use growth assets (stocks) for returns and ‘safe’ assets (bonds) for stability and adjust the ratio to match the overall risk of your portfolio to your risk tolerance, it makes sense to go with the safest, most liquid, highest quality bonds only (government bonds) and omit low quality corporate bonds in order to get maximum portfolio stability per dollar of bonds in times of equity crisis.

In that case, due to the need for security of bonds to maintain their value, corporate bonds don’t make much sense as they tend to behave a lot like equities, and they go down together. Take a look at how high yield bonds fared during the 2000-2002 and 2008 downturns here or more graphically here (scroll down, blue = corporate, red = govt).

Vanguard goes the other way and diversifies globally, so they use a global aggregate bond fund in their diversified funds.

It will be up to you which way you go.

2. Australian vs Global bonds

To explain this, first we need to distinguish between systematic risk and unsystematic risk.

Unsystematic risk (also known as idiosyncratic risk) refers to risk specific to a single asset (such as a single company) or a single group of assets (such as a sector). Unsystematic risk can be diversified away. There’s no reward for taking this risk, so when you diversify and lower the risk, there’s no corresponding loss of reward either. This is why diversification is called the only free lunch – because by diversifying, you reduce the risk without reducing the return. Conversely, when you don’t diversify away unsystematic risk, you’re taking on a higher risk without getting a reward — kind of silly when you think about it.
Examples include – single company risk, single industry risk, fund manager risk.

Systematic risk refers to the risk inherent in an asset class itself. This cannot be diversified away. It is the risk that you get a higher expected return for taking.
Examples include – economic risk, interest rate risk, political instability, sector instability, small company risk.

Corporate bonds, just like stocks, have unsystematic risk by way of credit risk, which can and should be diversified away. So if you’re using corporate bonds, diversifying globally is essential to reduce or remove unsystematic risk.

Government bonds, on the other hand, don’t have credit risk. Just about all the risk is interest rate risk, which is systematic risk – the risk inherent in the asset class itself. For this reason, there’s little need for issuer diversification with government bonds – provided it’s from a politically stable, developed country.

So, if the purpose of bonds is safety, then with government bonds, there’s not much benefit with global diversification because there’s not much chance of the Australian government defaulting.

Although, one reason you may want some international government bonds is that fixed income markets around the world don’t all rise and fall at the same time, so including some (currency hedged) international government bonds would provide some volatility reduction in the bond allocation within your portfolio. If there was a global government bond fund available on the ASX (Australian stock exchange) that held government bonds only from developed countries, that’s be ideal, but when the options available are Australian government bonds (VGB/IGB) and global government bonds which also include lower quality bonds such as those of emerging markets (VIF), you need to think carefully whether you want to include low quality bonds.

3. Duration

The longer the duration, the greater the sensitivity to changes in interest rates, meaning that as interest rates move, the price of longer duration bonds moves further than bonds with shorter duration.
It’s worth noting that bonds with longer duration tend to have higher expected returns as compensation for future uncertainty.
Since they’re all intermediate duration, there isn’t much to decide on here anyway.

4. Yield

With bonds, yield is very closely related to risk, and since we’re using equities as our risky/growth asset, higher return, chasing yield with your safe asset class doesn’t make much sense. As soon as anyone mentions they get high yields with their bonds, don’t be seduced — it always comes with a higher risk.

VAF is the most commonly mentioned bond fund for individual investors. It does have a small amount of corporate bonds to improve the returns slightly, but they’re a small portion, and they’re also high-quality bonds.

IAF is BlackRock’s equivalent to VAF.

VGB has only the highest quality bonds (government bonds). It has marginally lower returns than VAF, but the risk is about as low as you can get and fits the purpose of a safe asset for those using equities for growth/risk assets and want their bonds to be as safe as possible.

IGB is BlackRock’s equivalent to VGB.

VACF and VCF are corporate bonds. The higher return comes with higher risk (credit risk), and that risk tends to show up when equities are falling. If you decide to use these, a considerable portion of them should be considered part of your risky allocation with stocks rather than as part of your safe allocation with high-quality bonds.

VBND and VIF are to diversify into international bonds. There isn’t much of a chance that the Australian government will default, but if you feel the need to diversify internationally, these are fine options.

There is also a managed fund that holds 70% VBND and 30% VAF, which offers a combination of high-quality Australian bonds and globally diversified bonds. This is what Vanguard uses in its diversified funds.

You really can’t go too wrong with high-quality intermediate (5-10 year) duration bonds of developed countries, which are in AUD (or hedged to AUD). Any of these would fit the bill – VAF, IAF, VGB, IGB, VIF, VBND, AGVT, or the combination fund mentioned above.

Bond fund expected returns

Assuming you use stocks for growth, the purpose of bonds isn’t for maximising return, particularly when you realise that higher expected return will always come with higher risk, which is precisely what you don’t want in your safe allocation. Having said that, it’s worth understanding the expected returns of bonds so that historical returns don’t mislead you.

Past returns of bonds are a flawed and meaningless measure

Recent returns for bonds are in no way indicative of future expected returns. If you assume it is, it will almost certainly lead to decisions based on a misunderstanding of what you’re invested in.

The reason returns have been higher over the past few years is due to interest rates falling. Anyone who bought their bonds before the fall in rates could just as easily have faced rates rising instead of falling, resulting in the actual return falling below their expected return instead of what happened where the actual return went above the expected return.

For instance, last year, rates fell 3 times (a total of a 0.75% fall), and consequently, bond value increased 3 times. However, this can’t happen every year because we’re now at 0.75%, so there isn’t much further interest rates can fall. It certainly can fall to zero and even below, but it just can’t really fall a lot more, so what happened last year could potentially happen again but not every year, and this is why you cannot go by historical returns.

Interest rates went crazy in the 1970s, all the way up to 17%, and over the last 40 years, it has come down from 17% to under 1%, so there has been higher than historical returns for bonds during these 40 years. At some point, the rates just can’t drop much more, and at under 1% interest rates, we’re around that point. It could hit bottom now or in one year or five years, but there just isn’t much room for it to fall to get the same kind of return it has had in the past. For this reason, historical returns are just not a useful measure of expected return.

So, what can we use to get a more accurate measure of what to expect?

Yield To Maturity (YTM)

With high grade bonds such as those issued from the government of developed countries (VGB, for example), YTM is a very accurate measure of expected return, where the expected return is like a weighted average of all possible or likely returns. At the time of writing, for VGB, it’s 1.3%

There is a risk of default with corporate bonds, so the expected return will be lower than the YTM, but for high quality bonds, the YTM is the number you should be looking at for your expected return.

Now, interest rates can go up, which will have a loss in bond price.
Conversely, rates can go down, which will have gains in bond price.

You don’t know which way it will go, so your expected return remains at 1.3% currently (in the case of VGB).

Home loan offset account

If you have a property loan, then an offset is a far superior choice to bonds for your risk-free allocation. The return is higher, and the risk is lower, so it’s a bit of a no-brainer.

If that’s not enough, it’s also a tax-free gain!

A redraw facility is not an offset account

An offset account is legally a savings account. Any money in there is still your money, and you can take it out whenever you like without restriction.

Paying money into a redraw facility is legally paying down the loan. Consequently, the bank can decide not to allow you to redraw it out – yes, this happens, for example, if they find out you lost your job, which incidentally is when you need the money.

Also, note that some smaller banks offer a product that they call an offset but is actually a redraw. You could be locking up a large amount of money without realising until it is too late. Always check the fine print.

Tax

Since bonds have the majority of their return as income which misses every type of tax benefit (franking, CGT discount, ability to delay paying tax until you’re retired and on a lower marginal tax rate), you need to be wary of the tax consequences.

When interest rates are not as low as they are now, you may want your bonds to be in a low-tax environment like super. The caveat is that while interest rates are around zero, the returns on high quality bonds are so low that it doesn’t really matter, and you may be better served using up the tax-advantages of super for stocks.

Bond funds vs individual bonds

To cut to the chase, the only reason to hold individual bonds is if you have a fixed date requirement for your funds to be used, such as a car upgrade in X years or a house deposit in Y years. In that case, an individual bond or fixed-term deposit makes sense. If you have no fixed date and instead reinvest their principal right back into new bonds, there is no benefit to individual bonds over a bond fund. Below is a longer explanation of this.

It is often said that with your bonds, you can make them as simple or as complicated as you want them to be. The simple end is using a bond fund. The complicated end is buying individual bonds with durations to match the time you will use them (if that is even known).

Bonds have interest rate risk and the magnitude of risk is dependent on the bond duration.

When interest rates go up, since the interest return on an existing bond is guaranteed at the previous lower rate to what is now available in the market, the bond goes down in value to compensate anyone who will buy it. Otherwise, they would just go and purchase a newly issued bond instead.

For example, let’s say you had a 7-year duration bond, and interest rates went up by 1%. Your principal would go down by 7% to compensate for the 1% interest lost each year for the remaining 7 years.

Conversely, if interest rates go down, but you still have the previous guaranteed rate that is higher, the value of the bond will go up.

If a bond is held until maturity, any drop in value resulting from an increase in interest rates is compensated by a corresponding increase in interest relative to the new value for the duration of the bond. Therefore, if you retain the bond until the maturity date, you will get the full amount back.

However, there are actually two interest rate risks with bonds.

  1. Price risk – where interest rates go up, and the corresponding bond price goes down, if you need to sell them before the maturity date, the increased interest rate relative to the new lower price does not have time to compensate you for the loss.
  2. Reinvestment risk – where interest rates go down, and you roll over into a new bond at a lower rate.

When the investment horizon equals the bond duration, the two interest rate risk components perfectly offset each other.

With bond funds, the investment horizon will never equal the duration because the bonds within them are renewed continuously.

Although if you’re investing for retirement as opposed to a fixed expense at a known time, you don’t have a fixed date because — a) you never know when a drop in equity prices will occur that you will need to draw on bonds, and b) you don’t know how long you will live.

Also, buying individual bonds are more work to manage. You need to keep track of all of them and renew them as they mature at various dates. They also lack diversification because a bond fund holds bonds of a range of maturities and yields as they are constantly renewed as old ones mature, all at different interest rates.

Some people use a ” bond ladder ” to avoid price risk (the risk of rates rising and resulting in a fall in price and needing to use that money before the interest rate compensates for the drop in value). They put one years’ worth of living expenses into individual bonds (or fixed-term deposits) each of 1, 2, 3, 4, and 5 years duration. Then each year, as one matures, they take that to live off and then take a year’s worth of living expenses from whichever asset class is higher in the rest of their portfolio of stocks and bond fund to buy a new 5-year bond (or fixed-term deposit). This is an attempt to balance the two risks with the unknown date you will need the bonds.

A simpler option some people use is to have a short term bond fund (say 3-year effective duration) and a longer term bond fund, so that if you need any funds sooner, the price risk is lower to draw from the 3-year duration bond fund, and you can leave the rest of your funds alone which you’re unlikely to need for a long time so you can reduce both risks.

You’re already seeing how complex this can become, and this barely scratches the surface with bonds. This complexity is why bond funds are often used. Generally, one of the medium-term duration funds (which is all that is offered in Australian bond funds anyway) often becomes the default option for simplicity.

The only reason to hold individual bonds is if you have a fixed date requirement for your funds, such as a car upgrade in X years, or a house deposit in Y years. Then an individual bond or fixed-term deposit makes more sense so that you can get the highest rate possible (as longer terms offer a higher return), and you eliminate both interest rate risks. Otherwise, if you reinvest their principal right back into new bonds, you have no gain over a bond fund.

Further reading