They are getting more and more complex.
More recent bond issues are for 10 or even 20 years, and this creates fishhooks. Most investors should own some bonds. But you should not invest in bonds unless you are a knowledgeable investor. Start by seeking independent advice.
Bonds used to be “vanilla”, at a fixed rate for 5 years, and then repaid.
More recently bonds have been issued with more and more complexity that tends to favour the borrower, not the investor (too many clever lawyers working for the borrower).
The average investor probably should have bonds as part of a diversified portfolio, but would be very wise not to try and do it him/herself.
In theory bonds are fine if you can select quality bonds, diversify widely and hold to maturity, but;
- It is hard to get quality bonds with a good interest rate (June 2012)
- It is hard to diversify widely in the small NZ bond market
- If you need money out before maturity it is all too easy lose money
What if you need your money before maturity?
The value of your bonds will have fallen fall if interest rates have risen.
You will be OK if you can hold till maturity, but what if you can’t?
Most bonds require a minimum of $10,000 and ideally any one bond would not be more than 5% of your portfolio.
To achieve this, you need to have $200,000 or more to buy individual bonds and get the appropriate diversification. Otherwise you would be better to use a bond fund.
Use a bond fund
The better way for the average investor who wants bonds is to invest in a low cost bond fund.
In NZ we can use the AMP Fixed Interest trust which has a good track record, holds about 100 mainly low risk bonds, and is widely diversified.
Offshore our preferred bond fund is the DFA 5 Year Fixed Interest trust which is spread across 80 to 90 AAA and AA rated global bonds, and is very low risk. The fund is hedged into NZ dollars so is unaffected by the exchange rate.
The fund was designed by Eugene Fama, a DFA director, who won the inaugural 2009 global Onassis award for services to global finance (no one in financial circles in NZ has won such a high award) . In keeping with the DFA philosophy, this is a low cost fund.
The average return has been 7.22% pa since inception in 2004
Money can be withdrawn anytime from both funds.
We like AMP for 30% of our bond money and DFA for 70%.
To get the best out of bonds ideally you would be able to consistently forecast interest rates, year in and year out. However no one can do so consistently.
If professional fund managers cannot do it, then the average investor has no chance.
DFA do not attempt to forecast interest rates, and instead use a strategy designed by Eugene Fama which has proved itself well over the past 7 years.
Investment is about time & diversification
Short time frame under 2 years – cash only
2 to 5 years – cash, bonds and a maybe small allocation to shares
5 to 7 years – lots of bonds and some shares
Over 7 years – maybe a few less bonds and maybe a few more shares
As always be prepared to be patient
Don’t be pulled to and fro, or emotionally swayed by the media into making hasty decisions