Busting key myths about bonds

Famous investor Warren Buffett once commented that investors should never have more than 75% shares in their portfolio and never less than 25% bonds and they should also never own more than 75% bonds and never less than 25% shares.

Australian SMSFs, however, do not hold even close to Buffet’s recommended level, with less than 1% in bonds. This is in stark contrast to investors in the US, UK and Europe who hold much higher allocations. Much of the reason for this is a lack of understanding of the fundamental truth about bonds versus shares: the two different asset classes complement each other.

Bonds are lower risk than shares in the same company and help to protect your capital. The reason is that if a company gets into trouble and is wound up, there is a legal structure dictating how cash and the proceeds of asset sales are applied.

In the event of wind-up or liquidation, funds are paid to the most senior investors in the capital structure (senior secured debt) first and these investors must be repaid in full before any funds are paid to investors on the next level. Then each level must be repaid in full before funds are paid to the next level (see the diagram below).

The position of your investment in the capital structure is crucial in determining its risk and whether the return you are receiving is enough.

Shares should deliver growth and higher returns than bonds but they are the highest risk investment in the capital structure. In contrast, fixed income securities sit higher in the structure and are safer in the event of wind-up or liquidation. Generally they are lower risk and offer lower returns than shares.

Including bonds and other fixed income securities in your portfolios should lower risk and volatility and help smooth returns.

Simplified Bank Capital Structure

Source: FIIG Securities

So, if your portfolio is just shares and deposits, you’re missing out on all of the other rungs in the capital structure and the benefits of those investments.

To find out how FIIG can help you access direct fixed income exposure, please feel free to contact me directly.

Angus Knight
angusk@fiig.com.au
02 9697 8723