Why Everyone Is Talking About Bonds Right Now

All right, so six years ago, we were apparently experts in virology. Two or three years ago, we were all experts in geopolitical warfare when the Russians invaded Ukraine. And today, Phil, it seems like we're on bond experts. Everyone's asking you about bonds. They've all got opinions. What do we think? Aren't you experts? It's definitely the topic at the moment. I reckon I'm getting asked about them a couple of times a week, at least. Yeah, definitely everywhere. Getting back to the basics here. So Zemiga's gonna put on the screen the current 10-year Australian bonds. The way the bonds operate is probably something we should get into. And it's probably one of the oldest, if not the oldest form of credit. And it's effectively just an IOU. It's just the current days, it's digital. But if you go back, it could be an envelope, it could be a handshake, and it's just saying, look, if you give me this amount of money, I'll give it to you in return, plus some interest. And a bond is that chopped up. That's how it basically works. You'll have a bond issuing, issuances. So you'll have corporates. So you'll have the CBA, BHP, all the way down to little small-cap businesses that you've never heard of before, maybe small mining businesses. And they need to raise some money. They wanna borrow some money from people. They'll write IOU notes. And then you could trade those on the market, like you would the stock market. You can also trade those IOU notes. Or you can go directly. You can go to a friend, you can get a lawyer, you can write a document, and then that itself is a written fixed-income contract, yeah. Yeah, so I suppose, why would companies do that? Why would these things exist? Well, it's pretty similar. Governments, I mean, the other topic that comes up a hell of a lot at the moment when I'm talking to people is the deficit. I mean, governments use these things to fund their deficits. They need to go and build stuff. They need money to build stuff. They gotta get it from somewhere. They might issue a bond. Companies, you know, they might issue a bond because they're trying to undertake a project or grow or finance something that the company's doing. Or, you know, banks might issue it as a way to fund further debt. They might issue bonds to raise capital to then be able to go and lend you money to buy your house. When you're saying bonds, so what is, so it's actually, so this specifically is, say, for example, you're a trans-urban. You wanna borrow $2 billion. You've got a couple of options. You could go to a bank, or you could offer equity in your business, but you don't wanna do that because you don't wanna give up equity in your business. You can borrow the money from a bank, but the interest rate on that might be, I'm just picking numbers out here, it might be sort of okay, but they want a lot of really onerous things from you. Or alternatively, you could create a lot of these little IOUs and say, look, I wanna raise $2 billion. I'm gonna go to the fixed income bond market. Who wants to give me an interest rate? And if that interest rate's at a level that they're happy to borrow that money, they'll issue that bond, and that's how it operates. Spot on. And so, you know, when you see these things, you'll see a variety of interest rates, you know? So, you know, you might get, oh, what's the 10-year government bond at the moment? It's at what, 5.4% or something? I think it's moved up. So we actually, this is a re-recording. We recorded this podcast last week, and actually the bond rates have gone up since we recorded it. I was like, there you go. Yeah, which is kind of interesting. Yeah, they've actually pushed up higher, yeah. Well, there you go. I was saying, like a 10-year government bond is sort of considered the risk-free rate, although you've got the best chance of getting your money back, lending your money to a government with a higher credit rating. So that's sort of the lowest rate kicking around in the market at the moment, which is actually crazy, because that's a great return on your money. So why does the government issue bonds instead of going to a bank? Ah, the bank's not going to have enough money to fund what the hell they need already. They can usually get better terms as well. The interest rates are sometimes better, but they've got more flexibility. They can write whatever they want in those contracts to give them that flexibility. So that's why, say, for example, the Victorian government, Queensland government themselves have individual bond issuances with different terms and different repayment terms. So you could have a one, five, 10-year bond. And what that means is, is that on that date of transaction, you will get your money back in 10 years' time if you hold that bond until maturity, plus your interest coupons. That's why it's so critically important you see this stuff in the news. I know Queensland government's been in the news lately at the risk of losing their AAA credit rating. And you might see this stuff in the news a bit and think, well, who the hell cares? Why does it matter? That's why it matters. You lose that credit rating, your credit rating gets downgraded. You now got to pay a higher rate of interest to be able to secure these bonds, which means you're just kind of blowing your deficit up in further every time you need to issue a bond because now your interest payments are higher. So that's why this stuff's important. And so, we talked about government bonds, but we've also spoken about how you can get corporate bonds or companies will issue them. And they will come with a range of interest rates as well, depending on how much risk you're taking by lending money to that company and how likely you are to get your money back. And so, you can see some low-grade or they call it sub-investment grade stuff kicking around. It's paying some really high interest rates, maybe even equity-like interest rates, but you can't look at that and think, well, that's a bond. I'm just lending my money to someone. They're going to pay it back. Well, now you've got to think about the risk of whether or not you're getting that money back the further down this sort of credit rating chain you go. And I also got some really weird things happening because the companies themselves get to make their own terms. For example, Google issued a 100-year bond. Yeah, right. And surprisingly, the market, like punters were happy to lend them that money, which is crazy, of betting on the credit worthy of Google. And it's a competitive market. So, when a bond is, before it's issued, there's an auction to see what level of interest rate is going to be decided. Generally, there's a good idea, but you actually don't know. So, for example, if there's a heavy level of buying, so people really want this bond, it will reduce the yield, meaning the interest rate you will be paid is lower because you feel very comfortable in holding that bond. Conversely, say, for example, any business that's in construction at the moment, construction business is going broke all the time, any of the very large construction firms trying to issue bonds, not that much demand in the market, therefore, they're going to have to pay a higher level of interest to attract the investors to then buy their bonds and then they can use that money to then do their development, et cetera. Especially with everything going on in the news at the moment, I think I'd be terrified to throw my money at a developer, but anyway, it's a separate story. So, look, we've probably talked a bit about what bonds are and a bit of technical jib-jab there, but why do any of you care that are listening when usually we're here talking about superannuation and retirement and all that sort of stuff? We care for a couple of reasons. Now, when your mate brings up a TikTok video he's seen from some influencer banging on about bonds, you can at least seem like you know what you're talking about but secondly, if you're in any of the major super funds in the country and you're probably holding a fair whack of these things. Probably like quite a lot, so somewhere between 20, 40% of a portfolio will be, we're looking at the my super options, depending on who it is, but if you're in a my super, that's like the default option of a default fund that you end up with, which is most people, that's what we end up with their super and there must be referred to as a defensive component of the my super funds, which are often put into bonds because that's seen as the defensive element. Is it defensive? Always. So I just want to throw a couple of examples up here. The actual value of the bond can move up and down. So for example, if I have a five-year bond that's issued, they're usually just issued at what's called $100 face value and what you'll do is you'll buy as many as you want at $100 and then you receive your coupon. At the moment, let's say it's 7% per annum. So you'll go minus $100 to buy one bond on say, whatever it is, the 1st of January, you hold that for the 12 months and over that timeframe, you'll receive $7 of interest. If you hold that, you don't sell it, you just hold it for five years, you'll just get that 7% and then that note will then give you the full money back, assuming the credit worthy of that business. Now, the face value, the $100 can actually drop, can actually go up a little bit too, but can actually drop quite a lot. So for example, if you were Virgin Australia in the 2020s, when flying was a bit of an issue, Virgin issued nearly a billion dollars of bonds in 2020, 2021. So they wrote IOUs to mom and dad investors in Australia and they received about a billion dollars of money to invest in their business via bonds. Those went to zero pretty quick. Some people didn't even receive an interest payment. That's a great part of your defensive portfolio. Correct. So just thinking about that, that was seen as a very safe business backed by some government over a billion dollars with a lot of money, a lot of smart money. And some people didn't even receive a single income payment on those bonds, they took it to zero. So these things are certainly not without risk. And if you hold a bond of a business that's, let's say for example, the value of diamonds is continually getting cut down and cut down and cut down. It's like pearls in the 1900s. Diamonds today are becoming almost worthless because of the Chinese are extremely good at making synthetic diamonds, which themselves have a lot of applications across manufacturing and a lot of industrial applications, but also in engagement rings. No one had to die to dig them out of the ground. 100%, right? So the value of those mining companies is really coming down. So the value of their IOUs is like, oh my God, these guys are a bit shaky. I'm not sure if I'm going to get my money back. I'll just sell this bond now. I'll just drop it in the market and at least I'll get some money back because I don't think they're going to be able to fulfill this debt obligation that's owing in five, seven, 10 years. So look, when you're talking about your superannuation funds and the stuff that's in there, you're probably going to have a fair chunk of government bonds. You'll have some corporate bonds. You may have even a little bit of sub-integration grade. You're probably not going to go too far down that chain. You wouldn't imagine most of the bigger funds. Ah, it depends how much money they're chasing yields. If you want to juice up your returns, you take on more risky businesses. So you've got to be very careful with that. This is true. But you'll see, you can still see the value of those, even though it's supposed to be part of your defensive portfolio, which is there to stop your balance falling too much in bad times. You will see that part of your portfolio at times will still go backwards. The value will still go backwards. And somewhat counter-intuitively, like Scott was talking about, where price goes up, yield goes down. So when you think about that, what that means in practice for your super fund is if you're holding bonds right now and interest rates go up, your bonds are now worth less than what they were purchased for. So the value of your bond portfolio will fall. Now, it depends on duration, which is how long are they holding these bonds? A 10-year bond is much more sensitive to price movements than what a five-year bond is. And there'll be a spread of these things in your fund. It's going to depend on how your fund's managing their duration and what their feelings are on interest rate markets and all that stuff. But the only bit you need to understand is the duration is how long until the bond pays you your money back. For example, a bond that's one year versus five years versus 10 years has different interest rate sensitivities. We won't get too much into it. But if you hold a bond that won't pay back for a really long time, it's very susceptible to interest rates and they need to pay you a higher level of income for you to lock that money up. But what you're hoping in those scenarios is that you're being compensated for, if you might be in a time where maybe the value of your bond's gone down and that's, maybe it's okay, it doesn't look great in your portfolio, but you're still probably getting an income, or you still are getting an income return from that thing, which will help prop it up. And I just had this conversation with a client the other day, because we actually popped out his portfolio and we were looking at all the underlying managers across all the underlying asset classes. So we're having quite a detail. So some clients couldn't care less and just say, has my balance gone up or has it gone down? And that's all they want to know. This guy wanted to get into the nuts and bolts of it. We're right digging into the portfolio. There's a couple of red lines on there. Green means good, red means gone down. I said, Phil, a couple of these are red. What are you doing about it? And my answer was, well, I'm not doing anything about it. That's what it's supposed to do. But specifically for the relevance of this conversation is it was global bonds that had fallen. The point I mean is that it's supposed to be, if everything's moving in the same direction at the same time, then we don't have an efficient portfolio. That portfolio is not going to mitigate risk the way it should. We need things that are not color related and sort of move separately to each other. So at this point in time, the equities were up, global bonds were down a bit, but the income return on it had actually been insane. So the thing had fallen by, you know, a couple of grand, but he had like 14 grand in income payments. Not a bad trade-off. That line item itself looked like it had fallen, but the overall portfolio had grown because it had spat a bunch of income into his cash account. Why do we hold any bonds in a portfolio? Well, a couple of reasons. First of all, bonds should have what's referred to as a low correlation with your equities or your stock market portfolio. So if we're looking at, say for example, a growth or a high growth investor, a growth fund will have about 70 to 80% of the portfolio invested into Australian international businesses, stocks on the stock markets. And having a buffer, which is the fixed income portfolio, which just chugs along, kicks out income every month, is really stable. And what you can do is you can use that income to then buy more equities, and then it just becomes this flywheel. If the stock market falls, this fixed income portfolio just keeps kicking on. Assume you've done the, I mean, I know we've spoken a lot of time about the problems with it, but a structured correctly portfolio on the fixed income side will continue to provide you an income even through those market downturns, which allows you to then buy things as they keep coming down. So it's this like really strong stability rudder to a portfolio. And depending on how much stability you want is kind of dictated where, how we put those portfolios together. Hey, Phil, tell me a time when that all goes wrong. There are times though, especially in high inflation times where you might see equity and bonds kind of somewhat correlated. They all fell together off the back of COVID, never an ideal scenario. And there were some large funds out there that were running a lot of duration in their bond portfolios that got hit very, very badly. You know, the other interesting thing about bonds is I guess just watching them in general, can give you a bit of a sense on where the markets maybe expect economies to be going, interest rates to be heading, all that sort of stuff. And so when we're sitting here talking earlier about, you know, just the fact that the 10-year bond yields risen just over the last few days, if you're holding a mortgage, that's probably not the sort of thing you want to say. Especially if you're Australia, you've crossed over $1 trillion of government debt as well. Yeah, well, that's right. Yeah, it just means there's a hell of an interest bill getting paid on that. That's this much interest per year and that much per month that us as taxpayers pay an interest on the prior government's borrowing money. Now, yes, maybe they use that money for projects that gave us a great return on their investment, but the way that you're looking at it, if you are borrowing, your investment needs to be much higher than the money that you're borrowing at. So if you're, for example, borrowing at a 5.5%, you need a return of double that maybe? I don't know, what do you reckon Phil? Probably, yeah, at least, yeah, double that's probably leaving a little bit of fat after you're paying tax on it. So you're around the barbecue, this is a topic of conversation, hopefully you understand how bonds work, why they're in portfolios, the benefit of them, rising interest rates, there are benefits for it, higher incomes for those people who are parking money in the bank account, the currency gets stronger. I mean, like we were speaking about, it's rising bond yields, long-term bond yields might not be what you want to see as a mortgage holder because it probably means that people are expecting some rate increases to come. But on the flip side, if you're a baby boomer and you're retired and you're out there living your best life, that's exactly what you want to see. You know, you probably, your mortgage is paid off and it's just a bit more money in your pocket every fortnight, which is a great thing, get out and enjoy it. Probably a self-perpetuating problem though, because if you're out there spending a bunch of money, inflation's going to go up, means interest rates are going to go up and away we go. I'm glad I'm not sitting in the RBA trying to make any decisions here. Phil, I was listening to a really interesting podcast this morning with Alan Collier, who was talking about Jim Chalmers, who's the current treasurer. And he goes, do you guys really want to be betting against Jim Chalmers at the moment? And what he's saying is, he's trying to make house prices stable or come down. So I'm not sure where I'm sitting, but I probably wouldn't be wanting to bet against that guy. This is Chris Collier on Alan Collier, his son's podcast, which was really fun listening to the two of them talking about his, the ABC journalist who's been doing finance for 50 years. But that was really something to think about as well. And if, you know, in terms of aggressive and defensive assets. Bonds can be seen as a stable asset and they are like a cake or a lasagna. They need to be in a portfolio. How much is up to taste and how much, and how the chef or the advisors put it all together. Far out, there we go. From bond yields to cake and lasagna. Can we get a better analogy? Can you guys come up? Miko, Miko the editor here. Miko, can you come up with something better? Come on, mate, jump in here. God, that was amazing. I can't wait to do an animation regarding the bonds and the lasagna. Can't wait, can't wait. I was trying to, I was honestly trying to think of something that's like layers, but I was trying to not make a Shrek reference about peeling onions or cakes. Yeah, yeah, can't do the onion. Bonds are like a lasagna. Ah, Phil, help me bring this podcast home. We've lost the viewers. Sorry, people. This is supposed to be an informative one. This is round two as well. This is really why we shouldn't record podcasts at night. Phil, bring it home. But anyway, look, bonds are a good part of your portfolio. Don't be fooled to think they'll never go backwards because they sometimes can, but hopefully they're spitting out some income along the way. Your particular flavor, apparently, of cake or lasagna will depend on what's appropriate for you and your advisor can help you through it. Let's wrap it up with that. Thanks, guys. Appreciate you watching. This is a fun podcast. What do you do if you're worried about rising interest rates, if you're worried about rising inflation? Unfortunately, inflation punishes those who do nothing. It's just the way the world works. So you need to do something. You need to talk to your friends, you need to do some research, talk to some advisors, book a meeting with Dan. That's just the reality of inflation. You need to make steps and look after your family. It's protected because the dollars you hold today will be worth less in the future. So you need to start doing something to make more money with it. Yeah, spot on. Exactly right. Well, there's not much else to say. I think we've done it. Thank you so much for watching, guys. This has been a great pod. We love the comments that are coming in and we will see you next week. Awesome, guys. Cheers to that. Catch you next week.