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This commentary is written by Vanguard Investment Strategy Group Principal Roger McIntosh. The title is The difference between fixed interest and cash

It was first published on Friday 11 May 2012

And is read by Michael Mullins

Please remember that advice in this podcast represents a general view. It is recommended that you seek specific financial advice, before making investment decisions.

The latest bouts of sharemarket volatility and this month’s cut in official interest rates once again highlight the crucial role of bonds in a properly diversified investment portfolio.

In simple terms, a bond is a commitment by the issuer to pay a so-called coupon or interest rate on set dates over a set term and to repay the principal upon maturity.

The coupon rate payable on a new bond varies depending upon interest rates at the time of issue, the term of the bond and the issuer’s creditworthiness. At one end of the risk scale are Government bonds with the highest possible rating and at the other end are bonds issued by companies with lower credit ratings. The credit ratings assess the likelihood of the bond issuer meeting their timely obligations to repay coupons and principal.

Bonds are negatively correlated to the sharemarket, providing a much-needed and low-volatile buffer from a downturn in share prices. Further, bonds lock-in a higher income at a time of falling interest rates.

One of the challenges for individual investors and self-managed super funds is to understand how bonds can work to their benefit, particularly when the sharemarket is highly volatile.

Bonds truly exhibited their defensive qualities during the global financial crisis and subsequent sharemarket volatility. The S&P/ASX300 returned a negative 38.9 per cent in the 2008 calendar year whereas the UBS Composite Bond Index rose by 14.9 per cent.

And in the 2011 calendar year, Australian shares returned a negative 11 per cent while Australian bonds returned a positive 11.4 per cent.

One of the characteristics of bonds is that investors who buy bonds when interest rates are rising can experience capital losses. This risk can be reduced by investing in a diversified bond fund with a variety of maturity dates and bond types.

And if interest rates are falling, existing bonds issued at higher rates provide the potential for investors to make a capital profit, providing some insulation from inflation.

In addition to providing a means to diversify a portfolio from higher-risk growth assets, bonds provide regular and reliable income as well as capital stability.

A key question facing investors is not so much whether they should be invested in bonds but how much of their portfolio should be in bonds.

The answer should much depend on an investor’s personal circumstances including age, years until retirement, tolerance to investment risk and professional advice received. Financial planners often suggest that investors increase their exposure to bonds as they grow older.

And that concludes the column

The difference between fixed interest and cash

from Vanguard Investment Strategy Group Principal Roger McIntosh.

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Please remember that advice in this podcast represents a general view. It is recommended that you seek specific financial advice, before making investment decisions.