Steady and reliable income

Bonds are classified as 'income assets' as they provide a steady and reliable stream of income. Fixed income is generally considered to be a defensive asset class, but bond values can fluctuate due to changes in interest rates. Bonds have a lower risk profile than shares, which means they don't offer the same capital growth potential.

The spectrum of bonds available ranges from practically risk-free (if held to maturity) Commonwealth government bonds, to semi-government bonds (issued by state governments) to corporate bonds (issued by companies). This bond menu offers a wide range of yields, and therefore meets a range of investor needs and risk appetites.

Corporate bonds do not have as high a credit rating as Australia's sovereign credit rating – or those of the states – so they are higher-yielding than government bonds, but consequently riskier. However, investing in investment-grade rated corporate bonds in both the Australian and global markets is generally safer than investing in the same companies' shares, as they are higher up the capital structure.

Easy, cost-effective access to the broad Australian bond market can be established by buying the iShares Core Composite Bond ETF (ASX code: IAF), or the investor can target only the "sovereign" (that is, commonwealth government bond) sector using the iShares Treasury ETF (ASX code: IGB). Income-oriented investors unwilling to accept the risk of inflation eroding their returns can specify their bond allocation into the Australian inflation-linked bond sector using the iShares Government Inflation ETF (ASX code: ILB).

Fixed income securities can give an investment portfolio an element of capital stability and a consistent flow of interest income. Moreover, bonds typically show a low correlation with shares, meaning that they can protect a portfolio against capital loss.

Simple diversification through ETFs

Historically, fixed income has been a difficult asset class for Australian retail investors to use. Most bonds were sold in prohibitively large minimum investment parcel sizes, which effectively locked retail investors out of the market, confining them to unlisted bond funds. But in 2012, the first fixed income exchange traded funds (ETFs) were listed in Australia. These gave local investors the ability to lock-in exposure in one ASX listed stock to a fixed income portfolio comprising investment-grade securities, Australian commonwealth government bonds and state government bonds.

As has happened in the equity space, the addition of global fixed income ETFs has allowed Australian investors to gain exposure to international sovereign bonds, bonds from 'supra-national' issuers (for example, the World Bank) and foreign companies. The global bond ETFs also add high-yield bonds (corporate bonds that are not rated investment-grade) and emerging market bonds to the local menu.

For example, the iShares Core Global Corporate Bond (A$ Hedged) ETF (ASX code: IHCB) offers a simple, low-cost exposure to global investment-grade corporate bonds, spanning multiple countries and sectors. The iShares JP Morgan US$ Emerging Markets Bond (A$ Hedged) ETF (ASX code: IHEB) does the same for the US$-denominated global emerging markets bond market.

Some hedged international bond exposure can potentially reduce a portfolio's overall volatility. Like shares, investors have the choice of hedging the currency exposure of global bonds back into the Australian dollar. If hedged, this allows the investor to earn foreign market income and take advantage of potential foreign bond price appreciation, without being affected by currency fluctuations. (All of the iShares international fixed income ETF range is hedged to Australian dollars, to remove the currency risk for the Australian investor).

Redressing equity bias

Historically, Australian investors have shown a strong bias towards shares, particularly domestic shares. This has been cemented over the last few decades by the strong attraction of the dividend imputation system (introduced in 1987) – stemming from the subsequent boost to returns provided by franking credits – as well as a series of government privatisations and de-mutualisations of large insurance companies that served to swell the ranks of shareowners.

This bias towards shares has extended into retirement funding portfolios. According to the Australian Association of Super Funds (ASFA)¹, Australian super funds hold 48% of their assets in listed investments, with Australian shares their single largest allocation, at 23% of assets, followed by international shares at 21%. (Real estate investment trusts, or REITs, fill out the listed portion, accounting for 4% of total assets.)

However, this predilection for shares puts Australia out of step with international practice. In most of Australia's peer group of developed countries, bonds are by far the dominant asset class in retirement funding.

According to data from the 2015 OECD Pensions in Focus² report, the average pension fund (in a sample of 31 developed countries) holds 51.3% of its assets in bills and bonds, and 23.7% of its assets in shares. The same report puts Australian pension funds' allocation to bills and bonds at 8.8%, while 50% of the assets are held in shares.

Australia's growing army of self-managed super funds (SMSFs) diverges even further from the normal preponderance of bonds in pension funds. According to Australian Taxation Office (ATO)³ statistics, as at March 2016, Australian SMSFs held $6.7 billion in debt securities, or just 1.2% of the $570.6 billion in SMSF assets. In contrast, SMSFs own $172.1 billion worth of shares, or 30.2% of their assets.

The upshot of these statistics is twofold. Firstly, the asset allocation of the Australian pension system, being much lower in bonds, is not as conservative as that of its OECD peers – that is, it is arguably more risky. This applies particularly to Australian SMSFs.

Secondly, Australian SMSFs' minuscule collective holding in bonds means that these funds are not well-diversified as a group. Using selected domestic and global bond ETFs can redress this asset allocation anomaly by cost-effectively establishing a portfolio holding in fixed income.

¹ Source: http://www.superannuation.asn.au/resources/superannuation-statistics

² Source: http://www.oecd.org/finance/private-pensions/pensionmarketsinfocus.htm

³ Source: https://www.ato.gov.au/Super/Self-managed-super-funds/In-detail/Statistics/Quarterly-reports/Self-managed-super-fund-statistical-report-March-2016/?anchor=Assetallocation#Assetallocation

Disclaimer: This is a sponsored article by BlackRock Investment Management