- Investment strategies
- Why invest in the stock market?
- Buy and hold or technical analysis? Why you need an investment plan
- Value investing and short selling in volatile markets
- Using technical analysis to support value investing
- Investing in the unexpected
- Franking credits, explained
- What is dividend stripping and is it a sensible strategy?
- Investing in quality IPOs
- How to invest in stocks that benefit from a moving Australian dollar
- Reasons to avoid bonds when interest rates are low
- How value investors use Skaffold
- Quality, growth and value = a winning strategy
- Know your investor type and boost your performance
- Technical + fundamental analysis = better buy and sell decisions
- Fundamental investing
- Value investing and the price earnings ratio
- Intrinsic valuation models and methodology
- Value investments or value traps?
- How to find value stocks in a bull market
- Find value investments in expanding markets
- Why capital raisings struggle to add investment value
- How to value an insurance company
- Top stocks
- 5 qualities of top stocks
- How to find stocks with a competitive advantage
- Why return on equity is the best measure of business performance
- Using cash flow to find value investments
- Finding high quality dividend stocks
- Debt is not always a dirty word
- Why Skaffold share investment software makes sense
- Using economic factors to uncover the best investment options
- How do experts find top stocks to invest in?
- Investing in global stocks
- How to invest in international shares on global stock markets
- Benefits of investing in international shares
Reasons to avoid bonds when interest rates are low
If interest rates are falling, bond yields are too.
When interest rates reach record lows, investors are better off avoiding so-called ‘safe havens’ like government bonds and investing in top stocks with dividends.
If interest rates are falling, bond yields are too, and exposure to bonds can be more trouble than it is worth. Newcomers to this asset class may not know this.
Before adding bonds to your investment portfolio, you must:
• Recognise where we are in the cycle, and;
• Decide what role you want bonds to play in your overall portfolio.
As shares and bonds are uncorrelated assets, shares tend to do well when bonds are out of the money and vice versa.
It’s normal for investors to move out of bonds when share markets rally and invest more in bonds when the share market isn’t looking so bullish.
A danger of investing during a bull market is that you’ll lock in low yields via fixed-rate instruments (like bonds) – with a view to holding to maturity – effectively forfeiting the opportunity to receive higher returns elsewhere. That lost opportunity may not look like a big deal when interest rates are low. The negative impact will, however, rapidly accelerate once interest rates start going up.
Lost investment opportunity aside, you also need to ask yourself how exposed the capital values of bonds (as fixed rate instruments) are to interest rate movements (compare with floating rate instruments), and how this could also negatively impact the value of your portfolio.
AAA-rated government bonds provide an enviable level of credit quality. However, during bull markets the problem for would-be investors is the degree to which these bonds trade at premiums to their $100 face value.
How bonds work
An attractive annual coupon might be expected to offer anything from 5.25 per cent to 6.25 per cent, but remember that it’s not uncommon for capital values to exceed $110 and the further out that instrument is dated the higher the capital value is likely to be.
Once you see what can happen if bonds are held to maturity, you’ll start to understand why portfolios that hold bonds need to be actively managed. The combined impact of solid annual returns, plus capital losses on maturity (once you realise the bond’s $100 face value), is a yield of between 2.5 per cent and 3.5 per cent.
Here’s a classic example:
A Treasury bond is due to mature in five years, offering an attractive annual coupon of 5.5 per cent based upon a purchase price of $100.
The market has rallied and the bond is now trading at $114. Purchasing the bond at $114 results in a yield to maturity of 2.8 per cent.
If you’re considering adding bonds to your portfolio, use this calculation to figure out how much you will earn (the bond’s yield if held until maturity):
Current Yield = (Annual Dollar Interest Paid / Market Price) x 100 per cent
A bond with a $100 par value, trading at the discounted price of $95.92 and paying a coupon rate of 5 per cent, would have a current yield of 5.21 per cent.
((0.05 x $100) / $95.92) x 100 per cent = 5.21 per cent
Another argument for actively managing bond portfolios is the risk that in the lead-up to maturity yields will move higher as the 20-year bull market in government bonds comes to an end.
Should this happen, and portfolios aren’t actively managed, a move higher in yields will result in lower capital values and potentially negative returns as the value of coupons are offset by higher capital losses.
In an interest rate environment that favours shares over bonds, investors chasing yield would be better rewarded investing in high quality stocks with dividends.