- Get to grips with ratings and why some bonds are unrated.
- Beware of bonds that do not mature for 10 to 20 years.
- Be aware of the implications of subordinated bonds.
- Build a portfolio that can weather interest rate increases.
- Build a portfolio with staggered maturities (known as laddering).
- Remember NZ (Inc.) is not without risk.
- Never put all your money into NZ bonds, or all into NZ.
- Beware of any promoters who are receiving commissions.
- If interest rates rise, existing bond prices can fall, sometimes sharply.
- If interest rates are rising, it usually means the economy is doing OK. In which case shares will perform.
- Having a diversified portfolio of bonds and shares might be smarter.
- It could be argued that in the long run a diversified portfolio of bonds and shares is lower risk than a portfolio that only holds bonds.
Some un-rated bonds are probably fine, but you would need to be able to do an in-depth analysis yourself.
Perpetuals might get interesting (eventually)
Perpetual bonds and longer dated bonds usually reset the interest rate every year, or every five years, according to a present formula.
If interest rates are rising (as they will eventually) , some perpetuals that reset the rate annually might be quite good i.e. the return will rise along with rising interest rates, whereas a bond set for 5 years will not change the interest rate it is paying.
A perpetual with good reset provisions would be desirable, as its price will rise in anticipation if the market foresees an interest rate rise.
However you would be well advised to avoid perpetuals unless you really know what you are doing.
Long bonds with 10 & 20 year maturities
Bonds with long maturities are always a worry, so much can happen over 10 or 20 years, and they may or may not benefit from rising interest rates. Probably best avoided.
Some bank bonds look good, but are deeply subordinated.
Be aware that subordination can catch you out with major losses – fortunately fairly rare but it can happen !
Be aware of interest rates
Reserve banks round the world are holding interest rates at “artificially” low levels to try and help economies get back on their feet.
I.e. holding borrowing rates (“the cost of money”) very low to help companies and individuals.
We are told we are in a fragile recovery.
If and when a real recovery takes hold, interest rates will rise, and bond values will fall.
You can insulate your portfolio to some extent against this potential problem by using staggered maturities, not going too long, and maybe using some perpetuals.
Most bond portfolios should have staggered maturity dates e.g. some maturing in 2013, 2014, 2015, 2016, and so on.
Watch out for commissions
You might be surprised to see who is getting commission for selling bonds
It is not only individuals, but sharebrokers and banks too.
Selling bonds on commission is good for them, but will they be the right bonds for you?
If interest rates are rising, economies might be improving and share prices rising.
So don’t be in bonds only – in many cases it may be more risky to own just bonds than it is to own bonds and shares.
In the long run, it could be argued that a diversified portfolio of bonds and shares is lower risk than a portfolio that only holds bonds.
An Offshore Bond fund
It is all but impossible to get properly diversified in the small NZ bond market and so some offshore bonds are essential too.
Our preferred bond fund comes from Dimensional Fund Advisors (DFA) – a low cost fund with a simple yet sophisticated strategy. The fund holds mainly 80 to 90 AAA rated global bonds, is widely diversified, and is hedged into NZ dollars.
It has averaged 7.22% p.a. for the past 5 years.
The DFA fund can be included in most portfolios as it adds diversification and is very low risk. Funds can be withdrawn anytime.