Why We Don’t Use Bonds in Portfolio Construction.
In the investing world, there are two broad classes of investments, growth and defensive assets.
Growth assets are assets that aim to offer income as well as capital growth over the long term. These growth assets tend to have variable income and have a higher volatility in the short term but have traditionally had greater returns over the long term. Growth assets include but aren’t limited to shares, real estate and alternatives.
Defensive assets on the other hand aim to provide a stable and consistent income stream with a lower capital return over the long term. These assets are supposed to have lower volatility and lower long term returns than growth assets. Defensive assets include cash assets such as cash and term deposits and fixed interest investments such as bonds.
Most portfolios have an allocation to growth and defensive assets, however what these growth and defensive assets are can have different meanings.
Here at Evolution Financial Planning we have a preference for cash and term deposits over fixed interest products. The reason for this is that “fixed interest” investments are not capital stable, the fixed portion of fixed interest refers to the income being paid, not the price of the asset. People expect that their growth assets will rise and fall in price with markets, people do not expect their defensive assets to fall in price.
Bonds have had a remarkable run over the last 30 years as interest rates have been cut from 17% to zero. All else being equal, as interest rates are lowered, a bond is more valuable as the income they pay is fixed. Therefore on a comparative basis, that income is more valuable.
However, the reverse is also true, as interest rates rise bond income becomes less valuable.
The Vanguard Australian Government Bond Index ETF (ASX:VGB) is still down 16% from its peak in 2020. This is despite only being invested in bonds issued by the Australian Government, arguably the bond with the lowest risk of default in Australia.
People expect that their defensive portfolio will be capital stable. That is why we use cash and term deposits to ensure there is no price volatility in the defensive allocation within your portfolio and make sure you are able to fund the life you want to live in retirement.
