The Australian share market is valued at approximately $2.9 trillion. In comparison, the country’s bond market is worth more than half that amount, yet it remains relatively unknown to many investors. This includes bonds issued by the federal government, state and semi-government entities, as well as listed corporations.
This blog provides an overview of the investment options available to those looking to earn income without exposing their capital to significant risk.
When fixed income investments are appropriate
A fixed income investment is one that primarily generates predictable income and has a relatively stable market value. These investments are often referred to as defensive investments, meaning they are less sensitive to market fluctuations and economic downturns. There are several reasons why investors might be drawn to them:
- Portfolio Construction: A balanced portfolio typically includes a mix of defensive and growth investments. The idea behind holding defensive investments is to reduce overall portfolio risk and increase diversification. Defensive investments are usually less impacted by market and economic changes and can even be negatively correlated with growth assets like shares. This means, typically, when shares are declining, the value of bonds rises because during risky periods investors are more cautious and prefer less risky investments.
- Shorter Investment Horizon: In the share market, investors should expect negative returns about once every four years. Additionally, share markets tend to experience declines of 30% or more every 7 to 10 years, and it can take anywhere from six months to four years for the market to recover from a large decline. For those with an investment horizon of less than 10 years, fixed income investments may be more suitable, as they offer stability when there is less time to ride out market volatility.
- Low Risk Tolerance: For some investors, especially those who are already retired and/or nearing the end of their lives, capital preservation is often more important than long-term returns. In these cases, they may be happy to earn, for example, 5% p.a. if the value of their investments remains stable.
For those looking for fixed interest investments, here are some options:
Option 1: Mortgage offset account
If you have a mortgage, an offset account is often the best fixed-income/defensive investment. The reason for this is that the after-tax return on a mortgage offset is relatively high and without any risk.
First, an offset account generally offers one of the highest returns. If you deposit cash into a non-tax-deductible home loan offset account, the interest rate will be around 1.75% above the RBA cash rate (currently about 5.60%). To achieve a better return elsewhere, you would need to earn over 8% pre-tax, factoring in 30% for tax. If you are using an offset for a tax-deductible investment loan, the interest rate is likely to be about 2.25% above the RBA cash rate (around 6.10% p.a.), which still compares favourably to the other options discussed below.
Secondly, the return is risk-free – it’s guaranteed. Your return will be equal to the interest rate on your mortgage, which means there’s no risk involved.
Option 2: Term deposit
Most investors are familiar with term deposits, where your money is invested for a fixed period, and the bank pays you interest either at regular intervals or at maturity. If the term deposit provider is an Authorised Deposit-taking Institution (ADI), the government guarantees up to $250,000 in the event the bank fails. However, if you break the term deposit before it matures, you will typically face a penalty.
Term deposit rates are currently relatively flat, meaning investors are not rewarded for locking in their money for longer periods. In fact, the reverse is true, because the RBA is expected to cut rates a few times this year. The most cost-effective term deposit duration is typically between 4 and 7 months, where the best rates are around 0.70% p.a. above the RBA cash rate (currently around 4.55% p.a.).
Option 3: Fixed income ETF
As mentioned above, the Australian bond market is valued at over $1.5 trillion, offering a huge depth of investment opportunities. Like term deposits, bonds usually have a fixed duration and pay interest income (coupons) one to four times a year. Bond interest rates can either be fixed or variable (floating). The market value of a bond can be influenced by factors such as its time to maturity, the strength of the issuer, the bond’s rating, and expectations regarding interest rates and inflation.
Bonds are rated by agencies such as Standard & Poor’s (S&P), Moody’s, and Fitch. Bonds rated BBB- (S&P and Fitch) or Baa3 (Moody’s) and above are considered investment-grade, meaning the probability of default is generally below 1%. Non-investment-grade bonds, often referred to as junk bonds, carry higher risks and can vary significantly in quality. In most cases, I recommend sticking with investment-grade bonds.
There are typically four types of fixed-income ETFs:
- Government Bonds: These include bonds issued by the federal government, state governments, and semi-government entities. As these are highly rated, they are generally considered very safe investments. While the capital value can fluctuate, such as when the RBA surprisingly hiked interest rates in 2022, which led to a 10% drop in government bond values, however, such events are rare. Bond values tend to be very stable. Australian government bond ETFs, such as VGB, currently offer an income yield of around 2.8% to 3% p.a., which is almost 1% below the RBA cash rate. There are options to invest in global government bonds, such as VIF, but the yields tend to be lower.
- Corporate Bonds: These are issued by major corporations, including banks, financial institutions, infrastructure businesses, and other large corporations like Telstra and Goodman. Corporate bond values can fluctuate depending on the economic environment and the strength of the company that issued them. Australian bond ETFs like CRED currently offer yields of around 5.1% to 5.3% p.a. (1.35% above the RBA cash rate). HCRD is an interest rate-hedged version of CRED, designed to protect investors against the impact that interest rate changes may have on bond values, so capital is more protected. It offers a slightly lower yield of just under 5% p.a. Another option, SUBD or BSUB, provides a slightly higher yield (5.6-5.7% p.a.), but is almost entirely invested in banks, while CRED offers more diversification. However, all are good options. There are several global corporate bond ETFs available, such as IHCB, but similar to global government bonds, their yields are lower than those of Australian bonds.
- Composite ETFs: These funds invest in a mix of government and corporate bonds. An ETF such as OZBD generate yields around 4% per annum.
- Hybrid securities: Hybrid securities combine features of both shares and bonds. They pay a coupon, which includes franking credits, resulting in higher grossed-up, pre-tax income. Hybrids can automatically convert to shares, typically triggered when a bank fails to meet its capital adequacy ratios. For instance, in March 2023, holders of Credit Suisse hybrids lost their entire investment due to the bank’s collapse. While this risk exists, it’s highly unlikely for Australian hybrids given our banks’ strong credit ratings. Unlike Credit Suisse, which was barely investment-grade rated and under a credit watch, Australian banks are some of the highest-rated banks in the world. Another challenge for hybrid securities is a shrinking market, as ASIC has tightened rules on issuing hybrids to retail investors. Despite this, the big four banks still offer 18 hybrid securities, with an average maturity of over 6 years, so they will be around for a few years to come. BHYB is an ETF that includes all bank hybrids, offering a grossed-up yield of over 6.70% p.a., making it a notable option for investors seeking a strong income return with relative capital stability.
Most of these ETFs distribute income monthly, while some do so quarterly.
Interestingly, active bond managers tend to slightly outperform active equity managers. While more than 90% to 95% of equity managers failed to beat their benchmark, over the past 10 to 15 years, 68% to 82% of bond managers have not outperformed the index. This is still not a compelling performance. Also, given that bond returns are generally lower, it’s essential to focus on minimising fees, as fees are certain, returns are not. For this reason, I typically prefer index funds, as their fees are usually around 0.30% or lower.
Option 4: Alternatives
In addition to the options mentioned above, there are numerous alternative investment opportunities such as unlisted mortgage funds (like those offered by La Trobe Financial, the largest provider in Australia), non-investment-grade or emerging market bonds, and private credit funds.
Unlisted funds are not always easily convertible to cash. For example, many of these funds suspended redemptions during the Global Financial Crisis (GFC). They are also higher risk than investment-grade corporate bonds and sometimes lack transparency – you cannot necessarily ascertain their underlying risk.
Private credit has gained popularity in recent years as an alternative borrowing source to banks. These funds pool money from investors to lend to unlisted businesses and property developers.
It’s important to note that these alternative options typically carry much higher risks compared to safer investments like Tier-2 bonds issued by Australian banks, which are very safe investments. These bonds offer more than 5.5% p.a. in income with low risk. Considering this, why would one choose to take on significantly higher risk, higher fees, and less transparency just to potentially earn an additional 1.5%?
In summary
My first choice is to deposit cash into an offset account. If I do not have an offset account, my next preferred option is investing in Australian corporate bonds or hybrid ETFs.
